Managerial EconomicsCost and Production Analysis

Production FunctionRefers to a functional relationship, under given technology, between physical rates of input and output of a firm, per unit of time Q = f( Ld, L, K, M, T, t)Q = f (L, K)

Inputs based on short run & Long runVariable input: An input for which the level of usage may be changed quite readily.Fixed input: An input for which the level of usage cannot readily be changed and which must be paid even if no output is produced.Quasi-fixed inputAn input employed in a fixed amount for any positive level of output that need not be paid if output is zero

Types of Production Function based on Time Short Run: defined over as period of time over which inputs of some factors of production cannot be varied Q = f (L) Long Run: defined as a period of time over which all factors become variable Q = f (L, K)

Laws of Production Short run Laws of ProductionIn short run input output relation are studied with one variable input, other inputs as constantWith one variable input (Law of Variable Proportions/ Law of Diminishing Marginal Product)Long run laws of ProductionWith all variable inputs (Law of Returns to Scale)

Total Product & Average ProductTotal Product (TP) refers to total number of units of output produced per unit of time by every possible combination of factor inputs.Average product (AP) refers to total product per unit of a given variable factor. Thus dividing total product by quantity of variable factor, i.e. AP = TP/QVF

Marginal ProductMarginal Product (MP) : Owing to addition of a unit to a variable factor, all other factors being held constant, the addition realized in total product is referred to as marginal product, ie MP= TPN-TPN-1Also MP = TP/ QVF= a small change

Statement of Law of Diminishing Marginal ProductDuring short period under given state of technology and with given fixed factors, when units of a variable factor are increased in order to increase total product, TP may initially rise at an increasing rate and after a point it tends to increase at a diminishing rate because marginal product of variable factor in beginning may tend to rise but eventually tends to decrease.

IllustrationConsider the Kitchen at Mels hot dogs, a restaurant that sells hot dogs, French fries and soft drinks. Mels kitchen has one gas range for cooking hot dogs, one deep fryer for cooking French fries and one soft drink dispenser. One cook in the kitchen can prepare 15 meals (consisting of a hot dog, fries and soft drink) per hour. Two cooks can prepare 35 meals per hour. The marginal product of the second cook is 20 meals per hour. Adding a third cook results in 50 meals per hour being produced, so the marginal product of third cook is 15 (= 50 35) additional meals per hour.

Contd..Therefore, after the second cook, the marginal product of additional cooks begins to decline. The fourth cook, for example can increase the total number of meals to 60 per hour marginal product of just 10 additional meals. A fifth cook adds only 5 extra meals per hour, an increase to 65 meals. While the 3rd, 4th and 5th cooks increase the total number of meals prepared each hour, the marginal contribution is diminishing because the amount of space and equipment in kitchen is fixed, (i.e. capital is fixed). Mel could increase the size of the kitchen or add more cooking equipment to increase the productivity of all workers.

Law of Variable Proportions OR Law of Diminishing Returns (DMR)Law states when more and more units of a variable input are applied to a given quantity of fixed inputs, the total quantity may initially increase at an increasing rate and then at a constant rate but it will eventually increase at diminishing rates.AssumptionsTechnology is constantLabor is homogenousInput prices are given

Production Schedule showing diminishing returns

Units of Variable Input (L)TPAPMPStages of Returns1202020Increasing ReturnsStage I2502530390304041203030

Decreasing ReturnsStage II5135271561442497147213814818.51914816.401014514.5-1Negative ReturnsStage III

Note regarding Production scheduleLaw of DMR becomes evident in the marginal product column. Initially, MP of variable input [L] rises. TP rises at an increasing rate [=MP]. AP also rises . This is describes as stage of increasing returns.When 4th unit of labor is employed MP begins to diminish. Thus the rate of increase in TP slows down. This is the stage of diminishing returns.When AP is maximum, MP=APAs MP tends to diminish, ultimately becomes zero and negative thereafter [stage 3]When MP is zero TP is maximum. Further when MP becomes negative TP begins to decline in same proportion

Note: short run Law of DMR The optimizing rule in the context of a production function with only one variable input is to employ that number of units of the input at which the marginal revenue product equals the marginal variable cost or marginal factor cost.

Law of Returns to Scale-Long RunIn long run size of firm can be expanded as scale of production is enhanced as all factors are variableReturns to Scale refers to degree by which output changes as a result of given change in the quantity of all inputs in productionStatement of Law:As a firm in long run increase quantities of all factors employed, other things being equal, output may rise initially at a more rapid rate than rate of increase in inputs, then output may increase in same proportion of input, and ultimately output increase less proportionately.

Three Phases of returns in long run:

Law of Increasing returns: Percentage increase in input will lead to greater increase in outputQ/Q > F/FReasons: improvements in large scale operations, division of labor, use of technology, and realization of other internal economies such as managerial economies.If there are increasing returns then it is economically advantageous to have one large firm producing at relatively low cost rather than to have many small firms at relatively high cost. This rationalizes the existence of large power companies

Contd..Law of Constant returns: Percentage increase in input will lead to same percentage increase in outputQ/Q = F/FLaw of constant returns tends to operate when economies and diseconomies of scale are exactly in balance over a range of output. With constant returns to scale the size of firms operation does not affect the productivity of its factors.

Contd..Law of Decreasing Returns: Percentage increase in output is less than percentage increase in input, Q/Q

Economies of ScaleTerm Economies refer to cost advantagesThese occur when mass producing a good results in lower average cost.Economies of scale occur within an firm (internal) or within an industry (external).

Internal economies of scaleAs a firm expands its scale of operations, its costs will fall due to the benefits arising from expansion known as internal economies of scale. These benefits can be assessed by looking at changes in average costs at each stage of production as the firm moves into long run.By growing,afirm can expect to reduceitsaverage costs and become more competitive.How does a firm expand? A firm can increase its scale of operations in two ways.Internal growth, alsocalled organic growthExternal growth,also called inorganic growth - by merging with other firms, or by acquiring other firms

Types of Internal EconomiesLabor Economies: Division of labor resulting in greater degree of specializationAble to attract efficient labor as it can offer a wide vertical mobility, better prospects of promotion, etcTechnological Economies:More mechanized operations: At higher scale of operations more specialized and productive machinery can be used. For example using a conveyor belt to unload a small truck may not be justified, but it greatly increases efficiency in unloading a train or ship.

Types of Internal EconomiesFinancial economies:Fund raising capacity of the firm increases: Large firms can usually sell bonds and shares more favorably and receive bank loans at lower interest rates than smaller firms. Risk bearing Economies:By diversification of Market

Large firms can also achieve economies of scale or decreasing costs in advertising and other promotional efforts.

Types of Internal EconomiesMarketing EconomiesBuying material in bulk at cheaper costSelling and promotion costs are lesserPurchase can be done by expertsManagerial Economies:More expertise personnelPurchase economies: When an organization make a bulk purchase it gets benefits in the form of discounts

External economies of scaleThe lowering of a firm's costs due to external factors. External economies of scale will increase the productivity of an entire industry, geographical area or economy. The external factors are outside the control of a particular company, and encompass positive externalities that reduce the firm's costs.External Economies of ScaleAre those shared by a number of businesses in the same industry in a particular area.These are advantages gained for the whole industry, not just for individual businesses.

Types of External EconomiesEconomies of Localization: When a number of firms are located in one place all of them derive mutual advantages through training of skilled labor, provision of better facilities, etc. As businesses grow within an area, specialist skills begin to develop. Skilled labour in the area local colleges may begin to run specialist courses.Economies of Information: In large industry research work is done jointly

Diseconomies of Scale It occurs primarily because as the scale of operations increases it becomes even more difficult to mange the firm effectively and coordinate the various operations and divisions of the firm. The number of meetings, paperwork and telephone bills increase more than proportionately to the increase in scale of operation and it becomes increasingly difficult for top management to ensure that their directives and guidelines are properly carried out by their subordinates. Thus efficiency decreases and costs per unit tend to rise.

Types of diseconomy of scaleExampleCommunication As firm grows there are problems with communicationAs the number of people in the firm increases it is hard to get the messages to the right people at the right timeIn larger businesses it is often difficult for all staff to know what is happening Coordination and control problemsAs a business grows control of activities gets harderAs the firm gets bigger and new parts of the business are set up it is increasingly likely people will be working in different ways and this leads to problems with monitoring Motivation As businesses grow it is harder to make everyone feel as though they belong Less contact between senior managers and employees so employees can feel less involvedSmaller businesses often have a better team environment which is lost when they grow

Diseconomies of scale

Difficulties of managementDifficulties of coordinationDifficulties of ManagementIncreased RisksLabor DiseconomiesScarcity of Factor SuppliesMarketing Diseconomies

IllustrationConsider a dairy farm. Milk production is a function of land, cows, equipment and feed. A dairy farm with 50 cows will use an input mix weighted toward labor and not equipment (i.e. cows are milked by hand). If all inputs were doubled a farm with 100 cows could double its milk production. The same will be true for the farm with 200 cows, and so forth. In this case, there are constant returns to scale.Large dairy farms however have the option of using milking machines. If a large farm continues milking cows by hand regardless of the size of the farm constant returns would continue to apply. However when the farm moves from 5o to 1000 cows, it switches its technology toward the use of machines and in the process is able to reduce its average cost of production from Rs 10 to 7 per litre. In this case there are economies of scale.

Economies of scopeCost savings when different goods/services are produced under one roofScope economies are cost advantages that stem from producing multiple outputs Big scope economies explain the popularity of multi-product firms. Economies of scope exist when joint cost of producing two or more goods is less than the separate costs of producing the goods. In case of two goods X& Y , C(X,Y) < C(X) + C(Y)

Contd..Economies of scope arise when inputs can be jointly used to produce more than one productIt can also be in terms of administrative and marketing resourcesEg: Commercial banks use the same assets to provide variety of financial services, an oil well produces both crude oil and natural gas

*The Learning CurveLearning economies are distinct from economies of scaleLearning leads to lower costs, higher quality and more effective pricing and marketingOver a time when a firm accumulates its business experience it may tend to improve its production/organization methods with improved knowledge and experience of management and labor used in the production process. The firms learning experience would pay in terms of cost reduction.

What is Learning curve??In long run, these tends to the downward shifts in the average cost curves of the firm on account of learning on experience effect that improves productive efficiency of the firm in its operations over time.

LER= [1 ACt1/ACt0] x 100

*The Learning CurveAC1AC2ACQ2QQuantity

*Learning Curve StrategyExpand output rapidly to benefit from the learning curve and achieve a cost advantageMay lead to losses in the short term but ensure long term profitability

Sum on Learning Curve ConceptSuppose a firm develops a new PC model in 1995 with an average costs of Rs. 30,000 per unit. In 1996, however its average costs declined to Rs. 24,000 when other things being given and output is doubled. This may be simply attributed to learning effect. What is the learning effect rate [LER] in this case:

Cost ConceptsFixed & Variable costExplicit & Implicit costAccounting & Economic CostReal cost Private & Social Cost Replacement costHistoric & Future costProduction and Selling cost

Social CostsSocial costs of a firm are those that the society in general has to bear because of the firms activities . Social costs are external cost from firms perspective and social costs from society's point of viewThese costs are arise due to the functioning of the firm but are not explicitly borne by the firms Social cost includes Cost of resources for which the firm is not required to pay a price i.e. atmosphere, rivers, lakes, etc Cost in the form of disutility created through air, water pollution, etc.

Social costsThe relevance of social costs lies in the social costs benefit analysis of the overall impact of a firms operation on the society as a whole and in working out the social cost of private gains.The concept of social cost in the corporate sector has given rise to Corporate Social Responsibility (CSR).

Private costsPrivate costs are those which are incurred by a firm. Such costs are internalized costs that are incorporated in the firms total cost of productionThus the total cost of a firms commercial activity = Private costs (internal ) + Social costs (external)

Replacement CostReplacement costs refer to the current price or cost of buying or replacing any input at present.Every machine or equipment has a certain life in terms of its economic and technological utility. With expiry of its economic life the equipment must be replaced.Hence when an expenditure does not result in an increase in total assets, it is known as replacement cost a such as buying a new machine to replace the old one.

Historic & Future CostHistoric costs are incurred at the time of purchase of assets. They are also regarded as sunk costs as they cannot be retrieved from the business without loss.It is the amount paid in the past which is no longer relevant in decision making.Costs that firm incurs by launching a portal which cannot be recovered once the firm subsequently decides to discontinue the portal.Future costs include profit forecasting, capital expenditure program, etc.

Production & Selling costProductions costs are the costs related to the level of output.Selling costs are incurred on making the output available to the consumer.

Total Cost functions in the short runTotal cost (TC) is the full cost of producing any given level of output. Total cost is divided into two parts, fixed cost and variable cost. Total fixed cost (TFC) does not vary with the level of output. Total variable cost (TVC) varies directly with output.TC = TFC + TVC

Total Cost functions in the short runCost output relationship can be studied in short as well as long runTFC remains constant at all levels so it is a straight line parallel to X axisTVC is an inverse S shaped upward sloping curve starting from origin. The shape is determined by the law of Diminishing marginal returns. According to this law as more & more units of variable factor are added productivity initially increases at an increasing rate. This leads to fall in per unit cost in the beginning, as we increase the variable factor, other factors fixed, productivity of the input falls, so TVC curve is steeper on the upper side TC varies in same proportion as TVC since TFC is fixed.

Short-Run Cost CurvesTotal cost & Average cost curves

Average cost functions in the short runAFC decreases as output increases. Since total fixed costs remain same, AFC steeply initially spreading overhead over more units and then gentlyAVC is U shaped first decreases and then increases as output increases, this can also be explained with law of diminishing returnsATC or AC is U shaped. The logic is when AFC & AVC fall, AC falls. AVC soon reaches a minimum and starts rising while AFC continues to fall

Relationship between AC & MCWhen AC is minimum , MC is equal to ACWhen AC is falling, MC curve lies below itWhen AC curve is rising, after the point of intersection MC curve lies above itMC decreases initially but then increases as output is increasedWhen AC is minimum, AC = MC

Shifts in Short-Run Cost Curves

Cost schedule in short run for firm

QTFCTVCTCAFCAVCACMC01000100----11002512510025125252100401405020701531005015033.316.650104100601602515401051008018020163620610011021016.318.33530710015025014.221.435.740810030040012.537.550150910050060011.155.666.7200

Find out TC,AC and MC from the following table. Fixed cost i.e., FC=300 RS

No. of units producedVariable cost in Rs.100500200640300720400740500800600900

Complete the following table

unitsTFCTVCTCMCAC1203024537049551506220

SumSuppose Marutis total cost of producing 5 cars is 10.5 lakhs and its total cost of producing 6 cars is 12 lakhs, what is average cost of producing six cars? What is marginal cost of sixth car?

Long Run Cost behaviorLAC is derived as a tangent to various SAC curves appropriate to different levels of output. Also referred to as envelope curveLAC curve is less U shaped or rather dish- shaped. This means in the beginning it gradually slopes downwards and after reaching a certain point it gradually begins to slope upwardsThis behavior of LAC is attributed to the operation of laws of returns to scale. Internal Economies causes LAC curve to fall. It remains constant when economies equal diseconomies. Net diseconomies causes LAC to rise

Diagram for Economies and Diseconomies of Scale

Types of Long run Cost CurvesEmpirically it has been found that those industries where economies of scale are numerous as well as deep and diseconomies take considerable time to emerge LAC curve tends to decrease over long range of output and thereafter it tends to remain constant over a period of timeIn petroleum refineries, railways, steel plants etc have confirmed to this L shape (gradual)In some cases LAC curve has a rapid downward slope up to a certain range of output and thereafter curve becomes flat due to adoption of scientific methods in business such as financial controls, use of computers, delegation of decision making ie L shape (rapid)

*L-shaped Cost CurveIn reality, cost curves are closer to L-shaped curves that to U-shaped curvesReturns to scale vary considerably across firms and industries. Other things being equal, the greater the returns to scale, the larger the firms in an industry are likely to be. Because manufacturing involves large investments in capital equipment, manufacturing industries are more likely to have increasing returns to scale than service oriented industries. Services are more labour intensive

*Fixed CostsCertain inputs in the production process may not fall below a minimumIncreasing the volume of production yields economies of scale in the short runIn the long run, economies of scale are obtained through choice of technology

*Short Run & Long Run Economies of ScaleShort run economies of scale through better capacity utilization Long run economies of scale can be achieved by switching to high fixed cost technologyOutsourcing and nowadays firms also adopt global sourcing and try to attain international economies of scale or pursuing diversification as a growth strategy which can be organic or inorganic. Generally firms pursue inorganic growth strategies to be on higher growth trajectory (path). This is the reason why firms pursue M&As (Mergers & Acquisitions)

Why Firms Diversify

To grow i.e. achieve economies of scale To more fully utilize existing resources and capabilities.To escape from undesirable or unattractive industry environments.To make use of surplus cash flows.

Diversification as a growth strategyDiversification strategies are used to expand firms' operations by adding markets, products (related or unrelated), services, or stages of production (value chain) or within the sector (concentric) or across different sectors (conglomerate)Types of Diversification:Product diversificationMarket developmentHorizontal value chainVertical - value chainConcentric, andConglomerate

Organic strategiesRefer to internal growth strategies that focus on growth by the process of asset replication, exploitation of technology, better customer relationship, innovation of new technology and products to fill gaps in the market place. It is a gradual growth process spread over a few yearsApple Inc. is probably an excellent example of Organic Growth. organic growth strategies are business development techniques that grow a company via increased output and larger sales volume.

Inorganic growth strategiesRefer to external growth by takeovers, mergers and acquisitions, Joint ventures, strategic alliance. It is fast and allows immediate utilization of acquired assets. It is less risky as it does not result in expansion in capacity.Microsoft, on the other hand is a clear case of In-Organic growth as it has successfully completed more than 100 acquisitions since 1986. Eg: Skype communication, Hotmail

Concentric DiversificationWhen in concentric diversification new product or service is provided with the help of existing or similar technology it is called technology-related concentric diversification. For example, Mother dairy has added 'curd and Lassi to its range of milk products. In marketing-related concentric diversification, the new product or service is sold through the existing distribution system. For instance, a bank may start providing mutual fund services to its customers.

Concentric DiversificationWhen a firm diversifies into some business which is related with its present business in terms of marketing, technology, or both, it is called concentric diversification.Firms generally pursue concentric diversification to utilize the existing leverage or expertise that they have within the sector and to become most dominant player of that sectorAutomobile companies, Real estate players, firms in the IT sector generally pursue concentric diversification

Conglomerate DiversificationConglomerate diversification occurs when there is no relationship between the new and old lines of business; the new and old businesses are unrelated.a conglomerate is a multi-industry company. Conglomerates are often large and multinational.Several Indian companies have adopted this strategy, Reliance, Sahara, Essar group, ITC, Godrej, are examples of conglomerates

Conglomerate diversification

Firms pursue this strategy for several reasons:Continue to grow after a core business has matured or started to decline.To reduce cyclical fluctuations in sales revenues and cash flows.Problems with conglomerate or unrelated diversification:Managers often lack expertise or knowledge about their firms businesses.

Diversification: VerticalVertical integration occurs when firms undertake operations at different stages of value chain.In vertical integration new products or services are added which are complementary to the present product line or service. New products fulfill the firms own requirements by either supplying inputs or by serving as a customer for its output. In vertical integration the firm moves backward or forward from the present product or service.

Backward IntegrationWhen a firm diversifies closer to the sources of raw materials in the stages of production, it is following a backward vertical integration strategy.For example, a Car manufacturer may start producing tire tubes; Reliance Industries Ltd. Has been able to grow largely through backward integration. It started business with textiles and went for backward integration to produce PFY and PSF critical raw materials for textiles

Forward IntegrationForward integration means the firm entering into the business of distributing or selling its present products. It refers to moving upwards in the production/distribution process towards the ultimate consumer.The firm sets up its own retail outlets for the sale of its own products. For example, many companies like Bata, Bombay Dyeing, Raymonds and Reliance have set up their own retail outlets to sell their fabrics.

Example of Vertical IntegrationOil companies, both multinational (such as Exxon Mobil, Royal Dutch Shell, or BP) often adopt a vertically integrated structure. This means that they are active along the entire supply chain from locating crude oil deposits, drilling and extracting crude, transporting it around the world, refining it into petroleum products such as petrol/gasoline, to distributing the fuel to company-owned retail stations, for sale to consumers.

Diversification: HorizontalHorizontal integration or diversification involves the firm moving into operations at the same stage of production. In terms of value chain terminology, a horizontal integration keeps the firm at the same level of value chain. Most commonly seen in Banking sector through mergers & acquisitionsAdvantage is to achieve economies of scale and scope

Minimizing costs internationally International economies of scaleFirms must constantly explore sources of cheaper inputs and overseas production in order to remain competitive. This process can be regarded as organization's international economies of scale. This can be achieved in five basic areas: product development, purchasing, production, demand management and order fulfillment.

Global sourcingStrategic procurement concept with an international focus. A cross-border search is conducted for suitable suppliers that meet specific quality, time and price requirementsGlobal sourcing is defined as the process of identifying, developing, and utilizing the best source of supply for the enterprise, regardless of location

Global sourcing Most companies report a 10% to 35% cost savings by sourcing from low-cost-country suppliersThese days, the likes of Big Bazaar, Ebony, Shoppers Stop, Westside are looking to source merchandise at the lowest rates globally.Future Groups Pantaloon Retail India has just set up global sourcing offices in Hong Kong and Mainland China the first overseas sourcing operation by any domestic retail chain.India's biggest carmaker Maruti Udyog Ltd is toying with the idea of sourcing components from the global market as part of its strategy to become more cost competitive.

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