Managerial Economics

PGDM : 2019 – 21
Term 1 (July – September, 2019)
(Lectures 9,10, 11,12)

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Key Concept_PRODUCTION

– Production Function – Production with Multiple

• Concept of Marginal Variable Inputs: Long Run
and Average Product of Production Function
Input • Isoquant and it’s
– Production with One properties
Variable Input: Short Run • Concept of Input
Production Function Substitution: Marginal
• Law of Diminishing Rate of Technical
Returns Substitution
• Optimal Use of • Returns to Scale
Variable Input

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Key Concepts_COSTS OF PRODUCTION

• Key Concepts
• Measuring Cost: Which Costs Matter?

• Cost in the Short Run

• Cost in the Long Run

• Long-Run versus Short-Run Cost Curves

• Economics of Scale

• Production with Two Outputs—Economies of Scope

• Dynamic Changes in Costs—The Learning Curve

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Theory of Firm
• What is a firm?

– An organization that combines and organizes resources for the purpose of

production and distribution of goods and/or services and sales to
consumers/customers.

– In India, around 70% of goods and services are being produced and
distributed by firms. The not-for-profit organization and Government provide
the rest.

– However, in order to produce, an entrepreneur only needs essential resources

such as Land, Labor, Capital, Raw Materials. And for the distribution
purpose, a well defined distribution process would suffice.

– Now the question is: Why do we need an organization named as Firm? 4

Theory of Firm
• Why does a firm exist?

– Note that, a production or a distribution process consists of multiple steps.

– It is inefficient and costly for an entrepreneur to enter and enforce contracts with the owners
of the required resources for each separate step of production and distribution.

– It is less costly and advantageous to both parties - entrepreneur and resource owners - if there
is a longer term, broader contract between them, i.e., a General Contract.

– A General Contract internalizes many transactions through performing many functions

within the organization i.e. the Firm.

– Moreover, operating a firm, an entrepreneur can save sales tax and can avoid those
Government Regulations which are only applicable to transaction between firms.

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Theory of Firm

• So, if internalization reduces transaction cost then, should a firm expand

indefinitely?
• Answer is “NO”. But Why?
– It is very important to decide on the optimal size of firm since expansion beyond the optimal
point leads to “Diseconomies of Scale” i.e., increase in average cost with the increase in
output.
– Up to a certain point this diseconomies of scale can be avoided by establishing a number of
semi-autonomous divisions i.e., through decentralization.
– After a certain point on the expansion path of the firm, the distance between top management
from each division starts increasing.
– This in turn limits the management’s ability to effectively control and direct the operations of
the firm and impose sufficient diseconomies of scale to limit the growth of the firm.

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Theory of Firm

• Question:
– What is a firm getting out of it?

• Answer:
– Profit

• So, the next questions are

– What is Profit?

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 Theory of Firm
• What is Profit?
• Business or Accounting Profit
– Total revenue minus the explicit or accounting costs of production.
• Economic Profit (above normal profit)
– Total revenue minus the explicit and implicit costs of production.
• Opportunity Cost
– Implicit value of a resource in its best alternative use.
• The objective of a firm is to maximize the Economic Profit (π)
– Max (π) = Max (TR – TC) = Max {(P×Q) – C(Q)}
• To expand output : how shall the firm do that in short run and long
run?
• Given the ability to expand output how large to grow? 8
 The Technology of Production

• Production Function : Function showing the highest output that a firm can
produce for every specified combination of inputs. In fact, the production
function represents the particular technology a firm is using to combine the
inputs to produce the maximum possible amount of output from it.

• The Production Function Q  f ( K , L, E , M )

• Factors of Production: Inputs into the production process (e.g., labor,

capital, energy, and raw materials).
• Capital: land, buildings, equipment
• The labor can be categorized into
– Skilled Labor and
– Unskilled Labor
Examples of Production Functions
Efficiency : Technological and Economic

Technological efficiency : To produce a given level of output no

fewer inputs can be used.

A firm engages in efficient prodn if it cannot produce current

level of output with fewer inputs given existing knowledge about
technology and organization of prodn.

This is a necessary condition for profit maximization, BUT NOT

SUFFICIENT.

If the firm is producing too high or too low level of output and is
using expensive inputs, profit will not be maximized.

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 The Short Run versus the Long Run Production
Short Run : Period of time in which quantities of one or
more production factors cannot be changed.

Fixed Input : Production factor that cannot be varied.

Long Run: Amount of time needed to make all production inputs

variable.

Is capital always the fixed input?

No : Often skilled / highly specialized labour can also be difficult to
increase quickly.
Concept of Average and Marginal Product of an Input

Average Product : Output per unit of a particular input.

Marginal Product : Additional output produced as an input is

increased by one unit.

Average Product of Labor ( APL ) = Output/labor input = Q/L

Marginal Product of Labor ( MPL ) = Change in output/change in
labor input = ΔQ/ΔL
In the similar, manner we can define Average Product and
Marginal Product of Capital (K) and other inputs.
• A production function shows the maximum amounts of output that
can be produced from a set of inputs.

• All points on a production function involve technical efficiency.

The functional form of a production function is important because
it gives information about the marginal products of the inputs and
returns to scale.

• There are three main applications of production theory in terms of

managerial decision-making: capacity planning and evaluation of
trade-offs ( labour-labour, labour – raw material, capital - capital
( coffee machine vs photocopy machine)).

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Production With One Variable Input (Labor): Short
Run Production

Production with One Variable Input

Amount Amount Total Average Marginal
of Labor
0 (L) of Capital
10 (K) Output
0 (Q) Product
—(Q/L) Product —
(∆Q/∆L)

1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 4
10 10 100 10 8
 Quantity of Total Marginal Product Average Product
Variable Input Output of Variable Input of Variable Input

0 0 ___ ___
1 150    
2     200
3   200  
4 760    
5   150  
6     150
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Production With One Variable Input (Labor): Short Run
Production

The total product curve in (a) shows

the output produced for different
amounts of labor input.
The average and marginal products in
(b) can be obtained (using the data in
Table) from the total product curve.
At point A in (a), the marginal product
is 20 because the tangent to the total
product curve has a slope of 20.
At point B in (a) the average product of
labor is 20, which is the slope of the
line from the origin to B.
The average product of labor at point
C in (a) is given by the slope of the line
0C.
Production With One Variable Input (Labor): Short Run
Production

To the left of point E in (b), the

marginal product is above the
average product and the average is
increasing; to the right of E, the
marginal product is below the
average product and the average is
decreasing.
As a result, E represents the point at
which the average and marginal
products are equal, when the
average product reaches its
maximum.
At D, when total output is
maximized, the slope of the tangent
to the total product curve is 0, as is
the marginal product.
 Short-run Analysis
• The Three Stages of Production in the short run:

– Stage I: from zero units of the variable input to where AP is

maximized (where MP=AP)
– Stage II: from the maximum AP to where MP=0
– Stage III: from where MP<0
Short-run
Analysis
 Short-run Analysis
• In the short run, rational firms should be operating only in
Stage II

Q: Why not Stage III?  firm uses more variable inputs to produce
less output

Q: Why not Stage I?  underutilizing fixed capacity, so can increase

output per unit by increasing the amount of the variable input
 Short-run Analysis
• What level of input usage within Stage II is best for the firm?

The answer depends upon:

– how many units of output can the firm sell
– the price of the product
– the input costs
– the variable input
 https://www.youtube.com/watch?v=cTZ3rJHH
Sik

Sheer production of the Model T dramatically increased. The production time for
a single car dropped from over 12 hours to just 93 minutes due to the
introduction of the assembly line. Ford’s 1914 production rate of 308,162
eclipsed the number of cars produced by all other automobile manufacturers
combined.

These concepts allowed Ford to increase his profit margin and lower the cost of
the vehicle to consumers. The cost of the Model T would eventually drop to $260
in 1924.

In 1908, Ford Model T sold for $850 while rival vehicles sold for $ 2000 . By
early 1920s, Ford had increased production to 2 million cars per year.

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When may diminishing marginal returns not apply to a factor?

Thomas Malthus predicted in 1798 that if the population growth

remains unchecked, population will grow more rapidly than food
production because the quantity of land was fixed resulting in
mass starvation.

Today earth supports 7 times as much population.

 Production With One Variable Input (Labor): Short Run
Production
• The Law of Diminishing Marginal Returns to Factor:
Principle that as the use of an input increases with other
inputs fixed, the resulting additions to output will
eventually decrease.
The Effect of Technological
Improvement
Labor productivity (output per
unit of labor) can increase if
there are improvements in
technology, even though any
given production process
exhibits diminishing returns to
labor.
As we move from point A on
curve O1 to B on curve O2 to C
on curve O3 over time, labor
productivity increases.
 Production With Multiple Variable Inputs (Labor): Long Run
Production
• ISOQUANTS Production with Two Variable Inputs
LABOR INPUT
Capital Input 1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120

Isoquant: Curve showing all

possible combinations of inputs
that yield the same output.

In long run manufacturer can substitute one input for another to produce same level of
output. Isoquant depicts this flexibility that a firm has. The farther the isoquant from origin,
greater the output. Isoquants do not cross. Do not touch axes.
Production With Multiple Variable Inputs (Labor): Long Run
Production

Isoquant map: Graph combining a number of isoquants, used to describe a

production function.

Production with Two Variable Inputs

A set of isoquants, or isoquant

map, describes the firm’s
production function.
Output increases as we move
from isoquant q1 (at which 55
units per year are produced at
points such as A and D),
to isoquant q2 (75 units per year
at points such as B) and
to isoquant q3 (90 units per year
at points such as C and E).
Production With Multiple Variable Inputs (Labor): Long Run
Production

Diminishing Marginal Returns

Holding the amount of

capital fixed at a
particular level—say 3,
we can see that each
additional unit of labor
generates less and less
additional output.
Production With Multiple Variable Inputs (Labor): Long Run
Production
Marginal Rate of Technical Substitution (MRTS) : Amount by which the quantity of
one input can be reduced when one extra unit of another input is used, so that output
remains constant.
MRTS = − Change in capital input/change in labor input
Marginal Rate of Technical = − ΔK/ΔL (for a fixed level of q)
Substitution

Isoquants are downward sloping and

convex. The slope of the isoquant at
any point measures the marginal rate
of technical substitution—the ability
of the firm to replace capital with
labor while maintaining the same
level of output.
On isoquant q2, the MRTS falls from
2 to 1 to 2/3 to 1/3.

(MP ) / (MP )  (K / L)  MRTS

L K
30
Production With Multiple Variable Inputs (Labor): Returns to
Scale

● Returns To Scale: Rate at which output increases as inputs are increased

proportionately.

● Increasing Returns to Scale (IRS): Situation in which output more than

doubles when all inputs are doubled.

● Constant Returns to Scale (CRS): Situation in which output doubles when

all inputs are doubled.

● Decreasing Returns to Scale (DRS): Situation in which output less than

doubles when all inputs are doubled.

Returns to scale vary across firms and industries.

Q = KL, Q = L0.5 K 0.5 , Q = K 0.2 L 0.3

Returns to Scale: Graphical Exposition

When a firm’s production process exhibits However, when there are increasing
constant returns to scale as shown by a returns to scale as shown in (b), the
movement along line 0A in part (a), the isoquants move closer together as
isoquants are equally spaced as output inputs are increased along the line.
increases proportionally.
Returns to Scale: Mathematical Exposition

Production Function: Q  f ( K , L, E , M )

Suppose all the inputs are scaled up by an amount h and due to

this scaling up of inputs the output is scaled up by 
Therefore, Q = f(hL, hK)

Now,
If  = h, then the production function is exhibiting CRS.
If  > h, then the production function is exhibiting IRS.
If  < h, then the production function is exhibiting DRS.