SATHYABAMA INSTITUTE OF SCIENCE AND TECHNOLOGY

SCHOOL OF MANAGEMENT STUDIES

MANAGERIAL ECONOMICS
Subject Code: SBAB5102
MBA- SEM I
Faculty: Dr.M.Soundarya
 UNIT-3

The Production Function - Theories of Production - Law of

Variable Proportions - Law of returns to scale - Production
Isoquants - Iso cost Lines Estimating Production Functions - Cost
Concepts - Types - Cost in Short run and long run cost curves-
Estimation of cost function- Relationship between cost and
production.
 Production Meaning
 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
 Land
 Labour
 Capital
 Organization or Enterprise
 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 :
 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 3
 (vi) Land is a passive factor of production
 2. Labour

Labour is the human input into the production process. Alfred 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
 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 ‘organizer’.
 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.
 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...,
 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 II: Stage III:

• Stage of • Stage of • Stage of
increasing decreasing negative
returns returns returns
 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.
 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
Increasing
1+ 3 36 12 14
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
1+ 8 82 10.2 2 Return
1+ 9 82 9.1 0
1+ 10 78 7.8 -4 Negative Return
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.
 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.
 Three Stages of Returns to Scale
Scale of inputs Total Product Marginal Product Stages

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
8 Labour + 8 Capital 62 6 Returns
 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
 Production with two variable inputs
Combination Units of Labour Units of Capital Output in units

A 2 1 500

B 4 2 500

C 6 3 500

D 8 4 500

E 10 5 500
Diagram – isoquant Curve
 Characteristics of an isoquant

 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
Producers’ Equilibrium
 Contd..
 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
 Contd..

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.
 Contd..
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.
 ECONOMIES OF SCALE

Internal External
Economie economies
s of Scale of scale
 1.Internal Economies 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 Scale
Technical
Economies
Financial
Economies
Managerial
Economies
Labour
Economies
Marketing
Economies
 Contd..
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.
 Contd..
 3.Managerial Economies: Division of labor is the result of large scale
production. Right person can be employed in the right department
only if there is division of labor. 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. Labor Economies: Large Scale production paves the way for
division of labour. This is also known as specialization of labor. The
specialization will increase the quality and ability of the labor. As a
result, the productivity of the firm increases.
 Contd..
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 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
 Internal Diseconomies of Scale:
 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.
 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
 7. Opportunity Cost
 8. Sunk Cost
 9. Floating Cost
 10. Prime Cost
 11. Fixed Cost
 12. Variable Cost
 Contd..
 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.
 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.
 Contd..
 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.
 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
 Contd..
 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
Contd..
 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.
 Contd..
 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’.
 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’.
 Contd..
 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
 Contd..
 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’.
 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 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;
 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.
 Average Total Cost or Average Cost

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
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.
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.
 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.
 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’.
 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
 Explanation of BEP diagram

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.
 Concept of Revenue

Cost and revenue are just like two different faces of the same coin. The
costs and revenues of a firm determine its nature and the levels of profit.
Cost refers to the expenses incurred by a producer for the production of
a commodity. Revenue denotes the amount of income which a firm
receives by the sale of its output. The revenue concepts commonly used
in economics are total revenue, average revenue and marginal revenue.
 Total Revenue (TR)

Total revenue is the amount of income received by the firm from the sale of its
products. It is obtained by multiplying the price of the commodity by the number
of units sold.
Symbolically, TR=P × Q
where,
TR = Total Revenue,
P = Price and
Q = Quantity sold
For example,
A cell-phone company sold 100 cell-phones at the price of Rs. 500 each. TR is
Rs. 50,000. (TR= 500 × 100 = 50,000).
 Average Revenue (AR)

Average revenue is the revenue per unit of the commodity sold. It is calculated by
dividing the Total Revenue(TR) by the number of units sold (Q).
Symbolically; AR = TR /Q
Where,
AR = Average Revenue,
TR = Total Revenue and
Q = Quantity of unit sold.
For example,
If the Total Revenue from the sale of 5 units is Rs 30, the Average Revenue is
Rs.6. (AR= 30/5 =6) It is to be noted that AR is equal to Price.
 Marginal Revenue (MR)

Marginal revenue is the addition to total revenue by selling one more unit of the commodity.
MR can be found out by dividing change in total revenue by the change in quantity sold out.
Symbolically, MR = ΔTR /ΔQ
Where,
MR = Marginal Revenue,
ΔTR = change in Total Revenue and
ΔQ = change in total quantity.
The other method of estimating MR is:
MR=TRn –TRn-1 (or) TRn+1 – TRn
 Contd..
where, MR denotes Marginal Revenue,
TRn denotes total revenue of nth item, TR n-1
denotes Total Revenue of n-1th item and
TRn+1 denotes Total Revenue of n+1th item.
Example: Suppose 5 units of a product are sold at a revenue of
Rs.50 and 6 units are sold at a total revenue of Rs. 60. The
marginal revenue will be Rs.60 – Rs. 50 = Rs. 10. it implies that
the 6th unit ears an additional income of Rs. 10.
 Relationship between AR and MR Curves

 If a firm is able to sell additional units at the same price then AR and MR will be constant and equal.
 If the firm is able to sell additional units only by reducing the price, then both AR and MR will fall and be
different.
 When price remains constant or fixed, the MR will be also constant and will coincide with AR.
 Under perfect competition as the price is uniform and fixed, AR is equal to MR and their shape will be a
straight line horizontal to X axis.
 When a firm sells large quantities at lower prices both AR and MR will fall but the fall in MR will be more
steeper than the fall in the AR.
 When marginal revenue is positive, total revenue rises, when MR is zero the total revenue becomes
maximum.
 When price elasticity of demand is greater than one, MR is positive and TR is increasing.
 When price elasticity of demand is less than one, MR is negative and TR is decreasing.
 When price elasticity of demand is equal to one, MR is equal to zero and TR is maximum and constant.
 Significance of the concept of revenue

1. In determining the nature of profit: The concept of MR and AR both together constitute a
powerful analytical tool in economic analysis.
2. Helpful in Decision-making: the concept is also vital in determining the equilibrium of a firm.
The aim of every firm is to firm is to obtain maximum profits. The rule for profit maximization is
MC = MR.
3. Concept of Excess Capacity: This concept is helpful to indicate to the entrepreneur whether the
firm possesses excess capacity or not. Under perfect competition, production will be carried on up
to the minimum point of the LAC. Therefore excess capacity is not possible.
4. Factor-Pricing: In fixing the prices of factors in the factor markets AR and MR concepts are very
useful. In factor pricing the average revenue curve becomes the average revenue productivity
curve and marginal revenue curve becomes the marginal revenue productivity curve, ARP and
MRP are inverted ‘U’ shaped curves.