Lecture Notes on Engineering Economics and Project Management by B.

Guin || Contai Polytechnic

UNIT 2 –

2. 1. Economics of Production

Production is the process of combining various inputs, both material (such as metal, wood, glass, or plastics)
and immaterial (such as plans, or knowledge) in order to create output. Ideally this output will be a good or
service which has value and contributes to the utility of individuals. Each company is diverse and has a particular
production strategy that takes into account several factors when deciding how much to produce to be profitable.
Businesses must consider the cost of the inputs utilized in the production process. Similarly, firms must also
monitor the technology they use for production. Firms might either use labor-intensive factories or capital-
intensive factories, depending on which one helps them maximize their profit.

2.1.1. Factors affecting production

i. Land: Land has a broad definition as a factor of production and can take on various forms, from
agricultural land to commercial real estate to the resources available from a particular piece of land.
ii. Labor: Labor refers to the effort expended by an individual to bring a product or service to the market.
iii. Capital: In economics, capital typically refers to money. Money facilitates the processes used in
production by enabling entrepreneurs and company owners to purchase capital goods or land or to
pay wages.
iv. Entrepreneurship: a person who makes money by starting or running businesses, especially when
this involves taking financial risks. It combines all the other factors of production into a product or
service for the consumer market.
v. Production Technology: technology plays a vital role in influencing production. Technology can refer
to software, hardware, or a combination of both used to streamline organizational or manufacturing
processes. The introduction of technology into a labor or capital process makes it more efficient.

Technology
Making the production
process efficient

Production factors can be broadly classified as – Fixed and Variable, the difference is shown below:
Fixed Factor Variable Factor
These factors remain unchanged over-time in Variable factors change with the change of
the short-run, i.e., as the firm increases or output in the short-run, i.e., if the production
decreases its production in the short-run, fixed increases more raw-materials and labour will
factors remain constant. be required and vice-versa.

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It changes with the change in outpurt in the

It is independent of output in the short-run
short-run
E.g., plant machineries, land, factory buildings, E.g., Raw materials, daily wage labour, fuel,
permanent employees, etc. power, etc.
When production output is zero, the variable
It exists even at zero production output
factors also become zero.

2.2. Production Function

Production function is the functional relationship between physical inputs (or factors of production) and output.
For various quantities of inputs utilised, it gives the utmost quantity of output that can be manufactured.

Let us assume that a firm that manufactures output using only 2 factors of production – Labour (𝐿) and Capital
(𝐾). Then, the production function, explains the utmost quantity of output (𝑞) that can be manufactured by using
different combinations of these 2 factors of production.

We can write the production function as : 𝑞 = 𝑓 (𝐿, 𝐾)

2.2.1. Short-run Production

Short-run production refers to a production cycle in which at least one factor is fixed. Most companies have
multiple factors that they use to produce goods or services. Also known as input factors, they can consist of
labor, materials, equipment, capital and real property. Atleast one factor remain fixed in this case i.e., it does not
change throughout the course of production while other factors may fluctuate. It follows the return to factor
law, which can be stated as:

Return to factor law states that keeping other factors constant and when there is an increase in the variable
factor, the total product first increases at an increasing rate, then increases at a lower rate and eventually
declines.

The graph shown above shows the variation of production function for a short-run production that follows the
Return-to-factor law, 𝑇𝑃 – total production, while 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑖𝑛𝑝𝑢𝑡 include factors like labor, capital, land, etc.

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E.g., let us consider that the short-run production function of a firm depends on - Capital as a variable factor, and
Labor as a fixed factor. Initially the firm uses only six units of labor, and one unit of capital. So, its labor-to-capital
ratio is 6:1. Now if the capital is increased to two units, the labor-to-capital ratio will be 6:2 or 3:1. So, the labor-
to-capital ratio or the short-run production function will decrease when capital is increased.

2.2.2. Long-run Production

Long-run production refers to a production cycle in which all factors of production fluctuate. Regardless of
which factors a company uses to produce its goods or services, they are considered variable factors in long-run
production. Companies cannot accurately predict how many units of each input factor they will consume. Long-
run production involves the exclusive use of variable factors that can fluctuate. Here, all factors are varied in the
same proportion. The law that is used to explain this is called the law of returns to scale. It measures by how
much proportion the output changes when inputs are changed proportionately.

Law of Returns to scale refers to the change in output that results from a change in the inputs factors
simultaneously in the same proportion in the long run. When a firm changes the quantity of all inputs in the long
run, it changes the scale of production for the goods.

There are three stages of Returns to Scale:

1. Increasing returns to scale or diminishing cost refers to a situation when all factors of production are
increased, output increases at a higher rate. It means if all inputs are doubled, output will also increase
at the faster rate than double. Hence, it is said to be increasing returns to scale.

2. Constant returns to scale or constant cost refers to the production situation in which output increases
exactly in the same proportion in which factors of production are increased. In simple terms, if factors
of production are doubled output will also be doubled.

3. Diminishing returns or increasing costs refer to that production situation, where if all the factors of
production are increased in a given proportion, output increases in a smaller proportion. It means, if
inputs are doubled, output will be less than doubled.

The graph shown above shows the variation of production function for a long-run production that following
the 3 stages of Return-to-scale.

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E.g., let us consider that the long-run production function of a firm depends on - Capital and Labor as a variable
factor. Initially the firm uses only six units of labor, and one unit of capital. So, its labor-to-capital ratio is 6:1.
Now if the capital is increased to two units, the labor also becomes double (i.e. 12), hence labor-to-capital ratio
will be 12:2 or 6:1. So the ultimate outcome will be the same for the labor to capital ratio. The production is only
scaled-up.

Difference between Short-run and Long-run Production Function

Basis of Comparison Short-run Production Function Long-run Production Function
Meaning Short run production function alludes Long run production function connotes
to the time period, in which at least the time period, in which all the factors of
one factor of production is fixed. production are variable.
Law Law of returns to factor Law of returns to scale
Scale of production No change in scale of production. Change in scale of production.
Factor-ratio Changes Does not change.
Entry and Exit There are barriers to entry and the Firms are free to enter and exit.
firms can shut down but cannot fully
exit.

Comparison of “Returns to Factor” Vs “Returns to Scale”

Basis Returns to Factor Returns to Scale
Meaning The rise in the total product that results The change in output that results from a
from increasing just one factor while change in the factor inputs simultaneously
holding the other factors constant is in the same proportion in the long run is
known as Returns to Factor. known as Returns to Scale.
Factor Proportion In returns to factor, as the variable factor In returns to scale, the factor proportion
keeps on changing, the ratio of fixed and does not change.
variable factors also changes.
Scale of Production The scale of production in case of returns The scale of production in case of returns
to factor does not change. Only the to scale changes.
production level changes.
Time Period Returns to factor applies to the short-run Returns to scale is concerned with the
production function. long-run production function.
Reason for The output of the commodity changes with The output of the commodity changes
Operation the change in the marginal productivity of with the change in the efficiency of all
the variable factor. factors.

2.3. Cost Curve

Cost curve represents the relationship between output and the different cost measures involved in producing
the output. Cost curves are visual descriptions of the various costs of production. In order to maximize profits

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firms need to know how costs vary with output, so cost curves are vital to the profit maximization decisions of
firms. There are two categories of cost curves: short-run and long-run.

2.3.1. Short-run Cost Curves

The short-run production occurs for a time period short enough that some inputs are fixed while others are
variable. There are seven cost curves in the short-run:

1. Fixed cost (𝐹𝐶) is the cost of production that does not vary with output level. The fixed cost is the cost
of the fixed inputs in production e.g., as the cost of a machines.
2. Variable cost (𝑉𝐶) is the cost of production that varies with output level. This is the cost of the variable
inputs in production, e.g., daily wage workers, cost of raw materials purchased.
3. Total cost (𝑇𝐶) is the sum of fixed and variable costs of production, 𝑇𝐶 = 𝐹𝐶 + 𝑉𝐶
4. Average fixed cost (𝐴𝐹𝐶) is the fixed cost per unit output (Q). 𝐴𝐹𝐶 =
5. Average variable cost (𝐴𝑉𝐶) is the fixed cost per unit output. 𝐴𝑉𝐶 =
6. Average total cost (𝐴𝐹𝐶) is the fixed cost per unit output. 𝐴𝑇𝐶 = = +
7. Marginal cost (MC) is the additional cost incurred from the production of one more unit of output.
𝑑 𝑑 𝑑𝐹𝐶 𝑑𝑉𝐶
𝑀𝐶 = (𝑇𝐶) = (𝐹𝐶 + 𝑉𝐶) = +
𝑑𝑄 𝑑𝑄 𝑑𝑄 𝑑𝑄
𝑑𝑉𝐶 𝑑𝐹𝐶
𝑀𝐶 = ; ∵ =0
𝑑𝑄 𝑑𝑄

Illustration - Consider the cost variation with production output as shown in table below, the graphical plot of the
7cost curves can be generated as:

Average Average
Fixed Variable Total fixed variable Average Marginal
Output cost cost cost cost cost cost cost
Q FC VC TC AFC AVC ATC MC
0 50 0 50 – – – –
1 50 40 90 50 40 90 40
2 50 70 120 25 35 60 30
3 50 90 140 16.7 30 46.7 20
4 50 100 150 12.5 25 37.5 10
5 50 120 170 10 24 34 20
6 50 150 200 8.3 25 33.3 30
7 50 190 240 7.1 27.1 34.3 40
8 50 240 290 6.3 30 36.3 50
9 50 300 350 5.6 33.3 38.9 60
10 50 370 420 5 37 42 70

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The graph shown above shows the variations of cost function for a short-run production.

2.3.2. Long-run Cost Curves

In the long run, all inputs are variable, and there are no fixed costs. There are three long-run cost curves — total
cost, average cost, and marginal cost, which are actually derived from short-run cost curves.

1. Total cost (𝐿𝑅𝑇𝐶) curve is the line joining the expansion path, which is the combination of inputs that
minimizes the cost for every level of output.
Let us consider the cost 𝐶 to be a function of Labor 𝐿, 𝑟 is the rental rate or price of capital and 𝑤 is the
wage rate or price of labor. At different production quantity (𝑄 = 10, 20, 30) the variation of cost
function is obtained. Each of these cost curves have a minima, shown by points 𝑋, 𝑌, 𝑍 in the figure below.
These points give us the optimal combination of parameters for which the cost is minimum at each level
of production quantity. The minimum cost corresponding to the points 𝑋, 𝑌, 𝑍 plotted against the
production quantity gives the Long-run cost curve.

Cost curves at varying production output levels The long-run total cost curve

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2. Average cost (𝐿𝑅𝐴𝐶) is the cost per unit of output. It is the total cost (𝐿𝑅𝑇𝐶) divided by output 𝑄.
3. Marginal cost (𝐿𝑅𝑀𝐶) is the increase in total cost from an increase in an additional unit of output. It is
the slope of the total cost curve.

Long-run average and marginal cost curves obtained from the total cost curve in the previous figure.

2.3.3. Comparison of Short-run and Long-run Cost Curves

Short-run average costs are constrained by the presence of a fixed input. So in the long-run the cost can actually
be minimized by operating at the optimum parameters of the short-run cost function. For this, we consider that
the long-run cost function is a series of short-run average total cost curves, each one for a different level of the
fixed input, as shown in the figure below.

The long-run average cost curve as the lower boundary of short-run average cost curves.

2.4. Profit Analysis

Profit is the difference between the revenue received from sales and the total cost incurred for producing its
goods and services. The total cost of production includes explicit costs as well as any opportunity costs.

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Opportunity costs are a type of implicit cost determined by management and will vary based on different
scenarios and perspectives.

Explicit costs are out-of-pocket costs for a firm—for example, payments for wages and salaries, rent, or
materials.

Implicit costs are a specific type of opportunity cost: the cost of resources already owned by the firm that could
have been put to some other use. For example, an entrepreneur who owns a business could use her labor to earn
income at a job.

Advantages of Profit Analysis

i. Economic profit figures can be helpful for business decision-making. By studying the effect on net
income of subtracting not just explicit costs but the estimated costs of giving up potential business
opportunities, companies can size up the wisdom of business ventures from high to low before launching
one or more.
ii. Economic profit can also be reviewed after the fact. Lessons can be learned about the choices that were
made.
iii. Economic profit can show management how efficiently the company has been using its resources.

Disadvantages of Profit Analysis

i. The economic profit figure is theoretical because opportunity costs are based on assumptions. Since the
opportunity wasn't taken, a company doesn't know the exact amount of revenue that might have been
made.
ii. The calculation of economic profit over the short-term can lead to inappropriate conclusions about the
business option chosen. That's because short-term losses can be inevitable before expected long-term
profitability. It's smarter to analyze economic profits over long-term time periods.

2.4.1. Profit Maximization

Profit maximization refers to a tendency of business firms to maximize profits in the short or long run by using
the most efficient methods and equalizing the marginal cost and revenues. Its main purpose is to increase the
level of production of a firm or business that will grant it the maximum profit on selling goods and services.

Break-even Analysis

The main objective of break-even analysis is to find the cut-off production volume from where a firm will make
profit. Let
𝑠 = selling price per unit
𝑣 = variable cost per unit
𝐹𝐶 = fixed cost per period
𝑄 = volume of production

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The total sales revenue (𝑆) of the firm is given by the following formula:
𝑆 = 𝑠 ×𝑄
The total cost of the firm for a given production volume is given as
𝑇𝐶 = 𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 + 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝑣 × 𝑄 + 𝐹𝐶

The linear plots of the above two equations are shown in the figure above. The intersection point of the total
sales revenue line and the total cost line is called the break-even point. The corresponding volume of production
on the 𝑋 −axis is known as the break-even sales quantity. At the intersection point, the total cost is equal to the
total revenue. This point is also called the no-loss or no-gain situation. For any production quantity which is less
than the break-even quantity, the total cost is more than the total revenue. Hence, the firm will be making loss.

For any production quantity which is more than the break-even quantity, the total revenue will be more than
the total cost. Hence, the firm will be making profit.

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑆𝑎𝑙𝑒𝑠 – (𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 + 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠) = 𝑠 𝑥 𝑄 – (𝐹𝐶 + 𝑣 𝑥 𝑄)

The formulae to find the break-even quantity and break-even sales quantity

𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 =
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒/𝑢𝑛𝑖𝑡 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡/𝑢𝑛𝑖𝑡

𝐹𝐶
= (𝑖𝑛 𝑢𝑛𝑖𝑡𝑠)
𝑠−𝑣

𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠 = × 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒/𝑢𝑛𝑖𝑡
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒/𝑢𝑛𝑖𝑡 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡/𝑢𝑛𝑖𝑡
𝐹𝐶
= × 𝑠 (𝑖𝑛 ₹)
𝑠−𝑣

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The contribution is the difference between the sales and the variable costs. The margin of safety (M.S.) is the
sales over and above the break-even sales. The formulae to compute these values are:

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 𝑆𝑎𝑙𝑒𝑠 – 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛/𝑢𝑛𝑖𝑡 = 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒/𝑢𝑛𝑖𝑡 – 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡/𝑢𝑛𝑖𝑡

𝑃𝑟𝑜𝑓𝑖𝑡
𝑀. 𝑆. = 𝐴𝑐𝑡𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 – 𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠 = × 𝑠𝑎𝑙𝑒𝑠
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝑀. 𝑆. 𝑎𝑠 𝑎 𝑝𝑒𝑟 𝑐𝑒𝑛𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠 = (𝑀. 𝑆./𝑆𝑎𝑙𝑒𝑠) 100

P/V ratio is a valid ratio which is useful for further analysis. The different formulae for the P/V ratio are as
follows:
𝑃 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑆𝑎𝑙𝑒𝑠 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠
𝑟𝑎𝑡𝑖𝑜 = =
𝑉 𝑆𝑎𝑙𝑒𝑠 𝑆𝑎𝑙𝑒𝑠

The relationship between break-even point (𝐵𝐸𝑃) and 𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜 is as follows:
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
𝐵𝐸𝑃 =
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜

The following formula helps us find the M.S. using the P/V ratio:
𝑃𝑟𝑜𝑓𝑖𝑡
𝑀. 𝑆. =
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜

Problems for Practice:

1. Alpha Associates has the following details:

Fixed cost = Rs. 20,00,000
Variable cost per unit = Rs. 100
Selling price per unit = Rs. 200
Find:
(a) The break-even sales quantity, (b) The break-even sales
(c) If the actual production quantity is 60,000,
find (i) contribution and (ii) margin of safety by all methods.

2. Consider the following data of a company for the year 1997:

Sales = Rs. 1,20,000
Fixed cost = Rs. 25,000
Variable cost = Rs. 45,000
Find the following:
(a) Contribution, (b) Profit, (c) BEP, (d) M.S.

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