Production Cost & RevenueProduction, Costs and RevenueTo give basic idea about production function.To give basic idea about various costs and revenue concepts.To show the behavior and shapes of short and long run costs and revenue concepts and the reasons 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 Firm choosesLevel of output and fixed the priceCost of productionRevenuePriceOutput

Modeling

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 techniquesTechnical 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.

FirmBlack BoxThe Production FunctionInputs - 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 factors .

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 change 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 Factorsin the short run (SR), at least one of the factors is fixed in supply (the operating period)can split SR costs into fixed and variablefixed 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 factorThe 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 PRODUCTTotal 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/AQThis 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/LThis curve first goes up then goes downRelationship 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.

Average and Marginal Products

The Law of diminishing returnsAs 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 AnalysisCost 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 costAccounting cost and economic costExplicit vs implicit costsMarginal cost or Incremental CostSunk cost (while leaving industry you can not recover this costs) and fixed costShort 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 horizontal 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 labour add more value to production) and then increases at increasing rate (additional unit of labour add more to cost rather to production).

TC = TFC + TVC, TFC = TC - TVC, TVC = TC - TFC

Short-run Average Total Costs

TC/Q = TFC/Q + TVC/QATC = 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 changes 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 upOutput 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 fallsIf MC = AVC then AVC is at minimumIf MC > AVC then AVC risesSame relationship holds between MC and ATC

MRCost

OutputProfit maximising output Q1

Bringing FC and VC togetherCost ()Quantity (no. of units)0

ATC and MCCost ()Quantity (no. of units)0

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 businessJewellery retailingElectronic components manufactureElectricity generationSoftware developmentCellular telecommunicationsHotel management

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 runand 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.LR Average Costs

The Long Run Average Cost Curveunits of output0cost ()LRMCThe relationships between LRAC and LRMC same like in short-run.

Economies and diseconomies of scaleThere 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.

Returns to ScaleCost ()Quantity (no. of units)0Decreasing returns to scale

Increasing returns to scaleRead 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 scale1) Relocation of operation2) Contracting-out3) Reorganization of management structures4) Lay-off the workers5) 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 separatelyTC(Bn) = Total cost of producing Bn units of product B separatelyTC (An+Bn) = Total cost of producing A and B jointly

DES < 0 Negative ES. It is better to produce separatelyDES >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 ScopeEconomies of Scalesource : 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-run in competitive markets, firms can not survive if they have X-inefficiency problem: full efficient firms only survive. We can measure it as actual cost point - MES = (q1a-q1b) =ababq1LRACC0q

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 approach-At 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. Right placement of right people. Better co-ordination and control. Good integration of works. Better TQM Better project management and scheduling Cumulative outputCost per unitLRAC

Learning Effect Rate (LER)

LER = [ 1- (ACt1/ACt0)] *100

ACt1 = Average cost in initial period (t0) incrementACt0 = Average cost in next period (t1) incrementACt1/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 finance2) Pharmaceuticals3) Printing4) Road construction5) Recorded music industry6) Shoe manufacture & retail7) Training and education provision

Profits Maximization

Total Revenue - Total Costs = Profits

TR - TC = Profitsd(TR)/dQ - d(TC)/dQ = Marginal profitsMR = MC, Profits maximizing condition or ruleMarginal revenue = Marginal cost

Profits maximising output decision:MR > MC Q should goes upMR = MC Q profit maximising outputMR < MC Q should goes down

Profits maximising output and revenue maximising output are two different concepts (see next table).

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.MCQ0MC

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).MR/D/PMRAR =DPerfect CompetitionOther MarketsQPQP00

MRProfits maximising output Q1MR > MCMC < MR

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

Figure aFigure b

Normal Profits

At a breakeven point firm makes zero profits. But economists name it as a normal profits based on the opportunity cost concept.

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.

SRMCSRACSRAVCD1 =MR1D2 =MR2D3 = MR3D4 = MR4D5 = MR5P1P2P3P4P50Q1Q2Q3Q4Q5OutputPrice and CostThe Shut-down Position in Short-runAbnormal profitsNormal profitsShut-down price

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 costs2) Decreasing fixed costs3) Increasing the level of demand4) Combinations of all these

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