Engineering and Managerial

Economics Unit-III
PRODUCTION FUNCTION, OVERVIEW OF COST, PROFIT

BY DR. RAVI KUMAR GUPTA

MEANING OF COST

 In order to produce output any firm need to employ inputs or

factors of production like- land, labor, capital and organization
etc.
 The factors of production earn not a free goods but economic
goods.
 They are to be paid, when their services are utilized in the
production process.
 Land gets rent, labor gets wages, capital gets interest, and
organization gets profit and so on.
 cost of production therefore, is the payment made to the factors of
production for rendering their services in the production process.
COST FUNCTION

 Cost function means the functional relationship between cost and

output.
 It shows total cost at each level of output.
 Cost function can be expressed in the following way:-

C= f(Q)
Where:-
C = Total cost of production
Q= Unit of output
TYPES OF COST CONCEPTS:-

1. Opportunity cost:-

 The opportunity cost also known as alternative cost is the value of the choice
not obtained or benefits forgone to choose best alternative among many
alternatives.

2. Sunk Cost:-

 Firm in any industry have to spend money to earn money.

 A company budget may allow for investing money in employee’s salary,
inventory or any other cost of doing business.
 Once the company’s money is spent , that cost is considered as sunk cost.
 A sunk cost is that already being incurred can not be recovered.
3. Implicit & Explicit cost:-

 An implicit cost also called an imputed cost, implied cost or

notional cost is the opportunity cost equal to what a firm must
give up in order to use a factor of production for which already
owns and thus does not pay the rent.

 Explicit cost means, the cost of those factors of production whose

payment is made to the outsider or 3rd party. Explicit cost is also
called paid-out cost or out of pocket cost.
4. MARGINAL COST:-

 The increase or decrease in the total cost of production for one

additional unit of an item is marginal cost.
 In economics marginal cost is the change in the total cost arises
when the quantity produced is increased by one unit i.e.
 It is the cost producing one more unit of goods.
 For example- the total cost of producing 100 cell phone is Rs.
50000. when the firm produce one more cell phone i.e. 101, the
total cost become Rs. 54000
 Thus the marginal cost of producing cell phone is Rs. 4000
(Rs.54000 - Rs.50000).
5. INCREMENTAL COST:-

 Incremental cost is closely related to the concept of Marginal cost

but with the relatively wider connotation.
 It refers to total additional cost associated with the decision to
expand output or to add a new variety of product etc.
 It is the change in total cost as a result of change in the methods of
production or distribution such as use of improved machinery,
addition to a product, use of improved technology or selection of
additional sales channel.
 For example- if a company’s total cost increases from Rs.530000
to Rs.580000 as a result of increasing its labor hours , from 8 to 10
hours per day, the incremental cost of 2 extra labor hours is
Rs.50000 (Rs.580000 – Rs.530000)
6. SHORT RUN COTS:-

 Short run is a time period in which all cost can not be varied.
 Some inputs are fixed and other inputs remain variable during the
short run.
 Therefore short run cost of production can be divided into two
parts.
Short Run
Costs

Fixed Variable
Cost Cost
6(A). FIXED COST(TFC):-

 Total fixed cost is the cost that a firm incurs to employ the fixed inputs (like-
machinery, building etc.) is called fixed cost or total fixed cost.
 Whatever amount of output the firm produces, the cost remains fixed for the
firm in short run.
 The following table indicates that change in the quantity of output causes no
change in fixed cost.
 Assume when output is 0 unit, fixed cost is Rs.20.
Units of production Fixed cost (in Rs.)
0 20
1 20
2 20
3 20
4 20
5 20
6(B). VARIABLE COST(TVC):-

 The cost that a firm incurs to employ the variable inputs (like- raw material,
wages to labor, fuel or power etc.) is called the variable cost or total variable
cost.
 It is variable cost which changes with the change in the level of output.
 If output falls this cost also falls and if output rises this cost also rises.

Quantity of Variable cost (in

output Rs.)
0 0
1 4
2 7
3 10
4 13
5 15
6(C) TOTAL COST(TC):-

 Total cost is the total amount of expenditure incurred by a firm to produce a

given level of output.
 Thus by adding the total fixed cost and total variable cost, we get Total cost.
TC= TFC + TVC

Output TFC TVC TC

units
0 20 0 20
1 20 4 24
2 20 7 27
3 20 10 30
4 20 13 33
5 20 15 35
7. AVERAGE COST:-

 Average cost incurred by a firm is defined as the total cost per unit of output.
 It is the total cost of producing one unit of commodity.
 We calculate it as:-

AC= TC/Q

AC= Average cost, TC=Total cost, Q=units of output

 Average cost is composed of two types of cost:-

I. Average Fixed Cost (AFC)
II. Average Variable Cost (AVC)
7(i). AFC:-

 It is defined as the total fixed cost per unit of output.

 It’s the ratio of TFC to output (Q):-

AFC= TFC/Q

Quantity of TFC AFC

Output (Q) (TFC/Q)
0 20 -
1 20 20
2 20 10
3 20 6.67
4 20 5
5 20 4
7(ii). AVC

 Average variable cost is defined as total variable cost per unit of output.
 We calculate it as:-

AVC= TVC/Q

Quantity of TVC AVC

O/P (Q) (TVC/Q)
0 0 -
1 4 4
2 7 3.5
3 10 3.33
4 13 3.33
5 15 3
RELATIONSHIP BETWEEN AC, AFC & AVC

AC is the sum total of AFC &AVC

AC=AFC+AVC

Qnty. Of AFC AVC AC

O/P (Q)
0 - -
1 20 4 24
2 10 3.5 13.5
3 6.67 3.33 10
4 5 3.33 8.33
5 4 3 7
MARGINAL COST

 There is another important concept of cost namely Marginal cost.

 It is defined as the change in total cost per unit change in output.

Qnty. of TC MC
O/P (Q)

0 20 -
1 24 04
2 27 03
3 30 03
4 33 03
5 35 02
RELATIONSHIP BETWEEN AC AND MC
CONTINUED…..
 The MC curve intersects AC curve at its lowest minimum point.
 The left of the minimum point MC is less than the AC but to the right of minimum
point the MC
 At the lowest minimum point of AC curve, MC=AC
The relationship between AC and MC can be represent in the form of 4 main
points:-
i. When the AC curve slopes downwards, the MC curve lies below the AC
curve.

ii. When the AC curve is upward rising, the MC curve lies above the AC curve.

iii. When the AC curve is reaches its lowest minimum point Ac curve, MC=AC.

iv. For the 1st unit of output produced, there is no difference between AC & MC.
LONG RUN COSTS

 The long run is a period of time during which the firm can vary all its inputs.
 In the short run, some inputs are fixed and others are varied to increase the level
of output, but in the long run, none of the factor is fixed & all can be varied to
expand output.
 The firm has no fixed cost in the long run.
 Accordingly, there is no TFC and AFC curves in the long run.
 As there is no distinction between TC and TVC.

We simply use the term total cost, thus we have three concepts of long run cost:-
i. Total cost
ii. Long run average cost (LAC)
iii. Long run Marginal cost (LMC)
LONG RUN AVERAGE COST OR ENVELOPE COST

 It is a planning curve and it is guide to the entrepreneur in his decision to plan

further expansion of output.
 Long run average cost = Long run total cost / level of output
 The derivation of long run average cost is done from the short run average cost.
 Long run average cost is referred to minimum possible per unit cost of
producing different quantities of output of a good in a long run.
 In the short run plant is fixed and each short run plant is corresponds to the
particular plant.
RELATIONSHIP BETWEEN SAC AND LAC

 SAC represents the cost of a single plant, but Lac represents the

avg. cost of different plants.

 LAC curve like SAC curve is U shaped, but is relatively flatter.

 At a given level of output, it can not be more than SAC.

 LAC curve is not tangent to SACs , but to only one at their

minimum point.
LONG RUN MARGINAL COST (LMC)

 It is defined as the additional cost of producing an additional unit of output in

the long run i.e. when all inputs are variable.
 The LMC curve is derived at the point of tangency between LAC & SAC.
RELATIONSHIP BETWEEN LAC & LMC

 Since LAC curve is U shaped, LMC is also U shaped curve.

 When LAC falls, LMC lies below LAC and when LAC rises,

LMC lies above LAC.

 At the lowest point of LAC curve, both LMC & LAC are equal.

 LMC always cuts LAC from below its minimum point.

 PRODUCTION FUNCTION
“Production function is creating Utility”

In Economics,
“Production function means transformation of input into output”

Types of production
function

Short Run Production Long Run Production

Function Function
(FIXED) (Variable)
TYPES OF PRODUCTS

Total Product:- It is sum of total quantity of output produced by variable factors

along with units of fixed factors.
Average product:- It refers to the output per unit of variable factors.

AP = TP/L
Where, AP = Average Product, TP= Total Product, L=Labor

Marginal Product:- It refers to the additional product which can be derived by

employing one more unit of variable factor.
MP= TPL(n) – TPL(n-1)

MP=∆TP/∆L
Fixed Factor Variable TP AP MP
(Land) Factor (Labor)

1 1 20 20 20

1 2 50 25 30

1 3 90 30 40

1 4 116 29 26
LAW OF VARIABLE PROPORTION OR LAW
OF RETURN TO SCALE OR LAW OF
DIMINISHING RETURN
 It is related to short run product.
 As we increase the quantity of only input variables keeping other factors
constant,
 then the total product initially increase at an increasing rate,
 Then at decreasing rate and
 Finally at a negative rate.

 In other words as we employ more and more units of variable factor with the
given fixed factor, the proportion between variable factor to total product
change in such a way that the resulting output (MP)
 At first increases then diminishes and finally becomes and then negative.
SCHEDULE OF LAW OF VARIABLE PROPORTION

Fixed Variable TP AP MP
factor factor
(Land) (Labor)

1 1 100 100 100

1 2 210 105 110

1 3 330 110 120

1 4 420 105 90

1 5 490 98 70

1 6 490 81.6 0

1 7 488 69.7 -2
ASSUMPTIONS OF LAW OF VARIABLE
PROPORTION:-

 The firm operates in the short run. This means only one factor of
production is variable, while all other factors are constant or fixed.

 The technique of production does not change

 All units of the variable factors are equally efficient.

 Factors of production are not perfect substitutes of each other.

 Labor can not be fully replaced capital or vice-versa.

CAUSES OF VARIABLE PROPORTION:-
Causes of increasing return:-
1. Better utilization of fixed factor
2. Better co-ordination between the factors
3. Increase in efficiency of labor

Causes of diminishing return:-

1. Fixity of the factors
2. Imperfect substitutes of factors
3. Less co-ordination between the factors

Causes of negative return:-

1. limitation of fixed factors
2. Poor co-ordination between the factors
3. Decrease in efficiency of factors
ECONOMIES OF SCALE

 It refers to the advantages or benefits enjoyed by a firm or industry following an

expansion of its scale of production
 The advantage arises due to the inverse relationship between per-unit fixed cost
and the quantity produced. The greater the quantity of output produced, the
lower the per-unit fixed cost. Economies of scale also result in a fall in
average variable costs (average non-fixed costs) with an increase in output.
 It is also regarded as the benefits of large scale of production.
 There are two types of economies of scale.

Economies
of Scale

Internal External
Economies Economies
INTERNAL ECONOMIES OF SCALE

 When a particular firm of an industry enjoys certain advantages

following an expansion in its scale of production
 The advantages will be as internal economies of scale
 Different economies of scales are following:-

1. Financial economies:-
Most of the companies rely on borrowed funds, so as to fulfill their need for
money to finance the day to day operations and procurement of assets. When a
firm is large enough, its creditworthiness is also high, which facilitates them in
borrowing funds at a comparatively lower rate of interest.
CONTINUED……
2. Technical Economies:-
Technical economies have their influence on the size of the firm. Generally,
these economies accrue to large firms which enjoy higher efficiency from
capital goods or machinery. Bigger firms having more resources at their
disposal are able to install the most suitable machinery. Therefore, a firm
producing on large scale can enjoy economies by the use of superior techniques.

3. Managerial Economies:-
Managerial Economies of Scale occurs when the company employs highly
qualified, competent and trained managerial personnel, who can work
efficiently and effectively along with taking quick, sound and gainful decisions
for the firm. It also arises out of specialization. Specialization
of management functions means dividing the management of the company into
various departments, under specialized personnel, such as production manager,
marketing manager, human resource manager, purchase manager, sales
manager, etc.
CONTINUED……

4. Market Economies:-
A big firm will generate a higher demand for raw material compared to small
firms. The firm can get rebates by suppliers on bulk purchases. A big firm may
also undertake expensive surveys of market demand for its products.

5. Risk-Bearing Economies:-
 Large scale firms can easily bear the risk.
 A big firm can produce a no. of commodities
 If the demand for a particular product goes down in the market. The big firm
still can fallback upon the other products.
 They can easily cover the loans ensured by one or more units.
CONTINUED…..

6. Labor related economies:-

 The big firm has a large market for its products.
 It can go in a big way for division of labor & specialization. Such a firm can
offer various incentives like- rapid promotion, gratuity etc. to increase
efficiency of labor-force.

7. Economies in transport and storage:-

It takes place when the firm optimally utilizes its transportation and storage
facilities, as these two are required when the raw material comes in and also
when the finished goods go out, to/from the firm.
EXTERNAL ECONOMIES OF SCALE

 In external economies of scale, the company does not gain cost advantage
because of its own efforts, rather it is gained due to the expansion and growth of
the industry, market or economy, of which the firm is a part.
 It refers to the economies or benefits enjoyed by all firms which are generated
by the industry as whole.
 These are associated with the benefits of localization of industry.
 Sualkuchi is the centre of the silk industry of Assam.
 As & when the no. of loom increases, iot may be possible to establish a
sophisticated coloring and calendaring plant at Sualkuchi.
 This will benefit all the weavers.
 This is an example of external economies of scale.
External economies can be analyzed in following way:-
1. Economies of concentration:-
 When firms concentrate in a specific area they can get the benefits of several
aspects.
 These aspects may be skilled labor, better transport facilities, tax benefits etc.

2. Economies of information:-
 When a large scale industry publishes the reports, statistics & other
information regarding the products, markets, future aspects and other related
matters by its survey & research.
 Firms concentrated nearby can avail these necessary information and use them.

3. Economies of welfare:-
 Welfare policy of one firm compels the others to adopt sufficient measures for
the welfare of the workers and their families.
 Besides all firms can work together to bring welfare of the whole community.
 PROFIT ANALYSIS
Concept of profit:-
The term profit has different meanings for different people like economist,
businessman, entrepreneur etc.
“Profit simply means income over and above your all expenses.”
In accounting, profit is excess of revenue after all expenses of business. But in
economics, profit is reward of entrepreneur’s effort of combining all factors of
production and bearing risk of uncertainty. Profit in economics is termed as a
pure profit or economic profit or just profit.

Profit differs from the return in three respects namely:

a. Profit is a residual income, while return is a total revenue
b. Profits may be negative, whereas returns, such as wages and interest are always
positive
c. Profits have greater fluctuations than returns
TYPES OF PROFIT:
On the basis of fields, profit can be classified into two types, which are
explained as follows:
i. Accounting Profit:
 Refers to the balance of total income of an organization after deducting all
expenses and costs, including both manufacturing and overhead expenses. The
cost generally include explicit costs. The accounting profit is used for
determining the taxable income of an organization and assessing its financial
stability.
The accounting profit is calculated as:
Accounting Profit= TR-(W + R + I + M) = TR- Explicit Costs
TR = Total Revenue
W = Wages and Salaries
R = Rent
I = Interest
M = Cost of Material
CONTINUED…..

ii. Economic Profit:

Unlike the accounting profit, economic profit consider both the costs i.e. explicit
and implicit costs while calculating profit.
The economic profit is calculated as:
Economic profit = Total revenue-(Explicit costs + implicit costs)
Alternatively, economic profit can be defined as follows:
Pure profit = Accounting profit-(opportunity cost + unauthorized
payments, such as bribes)
Economic profit is not always positive; it can also be negative, which is called
economic loss. Economic profit indicates that resources of a business are
efficiently utilized, whereas economic loss indicates that business resources can
be better employed elsewhere.
THEORIES OF PROFIT:
Profits of businesses depend on the successful management of risks and
uncertainties by entrepreneurs. These risks can be cost risks due to change in
wage rates, prices, or technology, and other market risks. Different economists
have presented different views on profit.
Some of the most popular theories of profit are:
1. Walker’s Theory of Profit (Profit as Rent of Ability):
An American economist, Prof F. A. Walker propounded the theory of profit, known
as rent theory of profit. According to him “as rent is the difference between
least and most fertile land similarly, profit is the difference between earnings
of the least and most efficient entrepreneurs.” He advocated that profit is the
rent of exceptional abilities that an entrepreneur possesses over others.
Thus, profit is also said to be the reward for differential ability of the entrepreneur.
While formulating this theory, Walker assumed the condition of perfect
competition in which all organizations are supposed to have equal managerial
ability.
CONTINUED…..

2. Clark’s Dynamic Theory:

Clark’s dynamic theory was introduced by an American economist, J.B. Clark.
According to him, profit does not arise in a static economy, but arise in a
dynamic economy. A static economy is characterized as the one where the size
of population, the amount of capital, nature of human wants, the methods of
production remain the same and there is no risk and uncertainty. Therefore,
according to Clark, only normal profits are earned in the static economy.
However, an economy is always dynamic in nature that changes from time to
time.
According to Clark, the role of entrepreneurs in a dynamic environment is to take
advantage of changes that help in promoting businesses, expanding sales, and
reducing costs. The entrepreneurs, who successfully take advantage of changing
conditions in a dynamic economy, make pure profit.
CONTINUED…..
3. Hawley’s Risk Theory of Profit:

The risk theory of profit was given by F. B. Hawley in 1893. According to Hawley,
“profit is the reward of risk taking in a business.

According to him, the greater the risk, the higher is the expected profit. The risks
arise in the business due to various reasons, such as non-availability of crucial
raw materials, introduction of better substitutes by competitors, obsolescence of
a technology, fall in the market prices, and natural and manmade disasters.
Risks in businesses are inevitable and cannot be predicted. According to
Hawley, an entrepreneur is rewarded for undertaking risks.
CONTINUED…..
4. Knight’s Theory of Profit:
According to the theory, profit is a reward for the uncertainty bearing and not the
risk taking. Knight divided the risks into calculable and non-calculable risks.
Calculable risks are those risks whose probability of occurrence can be easily
estimated with the help of the given data, such as risks due to fire and theft.
The calculable risks can be insured. On the other hand, non-calculable risks are
those risks that cannot be accurately calculated and insured such as shifts in
demand of a product. These non-calculable risks are uncertain, while calculable
risks are certain and can be anticipated.
According to Knight, “risks are foreseen in nature and can be insured”. Thus, risk
taking is not a function of an entrepreneur, but of insurance organizations.
Therefore, an entrepreneur gets profit as a reward for bearing uncertainties and
not for risks that are borne by insurance organizations.
CONTINUED…..
5. Schumpeter’s Innovation Theory of Profit:
Joseph Schumpeter propounded a theory called innovation according to which
profits are the reward for innovation He advocated that innovation is the
introduction of a new product, new technology, new method of production, and
new sources of raw materials. This helps in lowering the cost of production or
improving the quality of production. Innovation also includes new policy or
measure by an entrepreneur for an organization.
In general, innovation can take place in two ways, which are as follows:
a. Reducing the cost of production and earning high profit. The cost of production
can be reduced by introducing new machines and improving production
techniques.
b. Stimulating the demand by enhancing the existing improvement or finding new
markets.

According to innovation theory, profit is the cause and effect of innovations. In

other words, it acts as a necessary incentive for making innovation.