production cost & revenue production, costs and revenue 1. to give basic idea about production...
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Production Cost & Revenue
Production, Costs and Revenue1. To give basic idea about production function.
2. To give basic idea about various costs and revenue concepts.
3. To show the behavior and shapes of short and long run costs and revenue concepts and the reasons behind that.
4. To give basic idea about economies of scales and scope concepts.
5. To give basic idea about profits maximization.
6. 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 price
Cost of production Revenue
Price
Output
Technology and costs of
hiring factors of
production
The complete theory of supply
Total cost curves,
short-run and long
run
Marginal cost curves, short-run and long
run
Firm chooses level of output
Marginal revenue curve
Demand curve facing the firm
(prices at which the firm can sell each
level of output)
Checks: Whether to produce at all
in short-run: whether to close down in long run
Average cost curves, short-run and long
run
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 techniques
Technical 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.
Firm“Black Box”
Outputs
The Production Function
Inputs - FOPs (Factors of production)(labour, land, materials, capital, knowledge, etc)
Inputs
FOPs
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 Factors
in the short run (SR), at least one of the factors is fixed in supply (“the operating period”)
can split SR costs into “fixed” and “variable” fixed 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 factor
The 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 PRODUCT
Total 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/AQ
This 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/L
This curve first goes up then goes down
Relationship 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.
Input Total Product Marginal Prod: Average Prod:Quantity of the Input of Input X of Input X
(X) (Q) (MPx= Q/ X) (Apx = Q/X)1 15 15 152 31 16 15.53 48 17 164 59 11 14.85 68 9 13.66 72 4 127 73 1 10.48 72 -1 99 70 -2 7.810 67 -3 6.7
Total Product, Marginal Product, and Average Product of Factor X, Holding Y=2
A A
Total, Average, and Marginal Product for Input X: Given Y=2
0
20
40
60
80
1 2 3 4 5 6 7 8 9 10
Input x
Out
put Q
TPx
-5
0
5
10
15
20
1 2 3 4 5 6 7 8 9 10
Input X
Out
put Q APx
MPx
Average and Marginal Products
The Law of diminishing returns
As 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 Analysis
Cost 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 cost
Accounting cost and economic cost
Explicit vs implicit costs
Marginal cost or Incremental Cost
Sunk cost (while leaving industry you can not recover this costs) and fixed cost
Short 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
Short-Run Cost Relationships
Q TC TFC TVC ATC AFC AVC MC1 120 100 20 120 100 20 202 138 100 38 69 50 19 183 151 100 51 50.3 33.3 17 134 162 100 62 40.5 25 15.5 115 175 100 75 35 20 15 136 190 100 90 31.7 16.7 15 157 210 100 110 30 14.3 15.7 208 234 100 134 29.3 12.5 16.8 249 263 100 163
16329.2 11.1 18.1 29
10 300 100 200 30 10 20 37
Short Run Cost Curves
Q1 Q2 Q3
Output per time period (units)
Total Costs
Fixed cost
Fixed cost = OF
Variablecost
Total Variable cost
Total cost
F
Increasing productivity of variable factors
Decreasing productivity of variable factors
O
$ per time period
Short Run Cost Curves
Q1 Q2 Q3O
MC
ATCAVC
AFC
MR
Cost
Output
Profit maximising output Q1
Bringing FC and VC together
TFC
Cos
t (£)
Quantity (no. of units)0
AFC
AVC
ATC
q1
ATC and MCC
ost (
£)
Quantity (no. of units)0
ATC
q*
MC
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 it’s 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 business Jewellery retailing Electronic components manufacture Electricity generation Software development Cellular telecommunications Hotel management
Long-Run Cost Curves
In the long run all the factors are variable and accordingly firm can change it’s scale of the operation. However firms can not change all the variables together. Therefore, long-run is going to be a series of short run periods.
During this period firms will change the scale of production (the amount firm is able to produce in relation to its size) which will affect for productive efficiency in three ways:
1) Constant returns to scale
2) Increasing returns to scale
3) Decreasing returns to scale
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 run
and so the LRAC curve is different from the SRAC we’ve 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 Curve
units of output
0
cost
(£)
LRAC
q1
SRAC1c1
q*
c*
SRAC3
q5
SRAC5
q2
SRAC2c2
SRAC4
q4
LRMC
The 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 Scale
Cos
t (£)
Quantity (no. of units)0
LRMC
LRMC
LRAC
LRAC
q1
Increasing returns to
scale
q2
Constant returns to
scale
Decreasing returns to
scale
Minimum efficient scale (MES)
Average (i.e. per
unit) cost of production
Output expansion over the long run
O q1 q2
Decreasing cost
production
Increasing cost
production
Constant cost production
Increasing returns to
scale
Decreasing returns to
scale
Constant returns to scale
The long- run average cost curve
Increasing returns to scale• Read 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 Scope
Economies of Scale
Real Economies Pecuniary Economies
Bulk buy raw materialsLower cost of finance
Lower cost of advertisingLower transport ratesLower R & D costs
Production
LabourCapital
Inventory
Selling/Marketing
AdvertisingLarge-scale promotion
Exclusive dealers
Managerial
Specialisation/team-workingDecentralisationMechanisation
Other
TransportStorage
R & D efficienciesBy-product production
Experience curves
source : adapted from Koutsoyiannis (1979)
X-inefficiency
The situation of wastage of firm’s 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) =ab
a
b
q1
LRACC
0 q
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 output
Cost per unit
LRAC
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.
2000For working examples see Mithani.D.M ( ), TTTTTT TTT TTTTTTTTTTTTT,,
-2801Himalaya Publishing House, Page
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).
Profit maximization & the Revenue maximization
P(per unit)
Qd PQd(TR)
TC(TFC+ TVC)
(TR-TC)
- 0 0 10 -10
21 1 21 25 -4
20 2 40 36 4
19 3 57 44 13
18 4 72 51 21
17 5 85 59 26
16 6 96 69 27
15 7 105 81 24
14 8 112 95 17
13 9 117 111 6
12 10 120 129 -9
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.
MC
Q0
MC
Marginal revenue is the increase in total revenue when output is increased by 1 unit. Its behaviour depends on the firm’s demand curve . Generally it is a downward for most market structures except perfect competition (horizontal).
MR/D/P
MR AR =D
TTTTTTT TTTTTTTTTTT TTTTT TTTTTT
T
Q
T
Q
T
00
Profits Maximization in Short Run
Q1 Q2 Q3O
MC
ATCAVC
AFC
MR 1Profits maximising output Q MR > MC MC <
MR
Comparative Static Analysis
MC 1
MC
MC 2
MC MR
0
MR
Q1 Q Q2
Q
Comparative Static Analysis
MC
MC MR
0
MR
Q1 Q Q2
Q
MR2
MR1
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<MC. Therefore the best point is Q2).
Figure a
Figure 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.
TTTC
SRACSRAVC
1 1D =MR
2 =D M2
3 =D MR3
4 =D MR4
5 =D MR5
P1
P2
P3
P4
P5
0 Q1
Q2 Q3Q4 Q5 Output
Price and Cost
- The Shut down Position in-Short run
Abnormal profits
Normal profits
- Shut down price
Exercise
Usage of profits maximizing model to loss making firm - Baldwin’s 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