Managerial Economics

Managerial Economics

Causes of Returns to scale Increasing returns to scale Economies of scale -Internal economies -External economies

Diminishing returns to scale Diseconomies of scale -Internal diseconomies External diseconomies

Causes of Increasing returns to scale • Economies of scale : It means reductions in per unit costs of production or benefits derived by expanding the scale of production. 2 types: Internal economies External economies

Internal economies • When a firm expands its scale of production, it enjoys certain benefits which lead to a reduction in its cost or increase in output. • They are specific to the firm which is expanding.

Internal economies Types: • Technical Economies • Managerial Economies • Marketing economies • Financial Economies • Commercial Economies • Risk and survival economies

Internal economies • Technical economies made in the actual production of the good. For example, large firms can use expensive machinery, superior techniques. • Managerial economies made in the administration of a large firm by splitting up management jobs and employing specialist accountants,

Internal economies • Marketing economies made by spreading the high cost of advertising on television and in national newspapers, across a large level of output. • Financial economies made by borrowing money at lower rates of interest than smaller firms.

Internal economies • Commercial economies made when buying supplies in bulk and therefore gaining a larger discount. • Risk and survival economies: A larger firm is in a stronger position to face uncertainties and risk of business.

External Economies • Those economies which are industry specific. • Available to all the firms in the industry when the scale of operation of the industry as a whole expands.

External Economies • Economies of Concentration • Economies of specialization

Economies of Concentration • A local skilled labor force is available. • An area has a good transport network.

Economies of specialization • Specialist local back-up firms can supply parts or services • An area has an excellent reputation for producing a particular good.

Causes of diminishing returns to scale • Diseconomies of scale • Diseconomies of scale are the forces that cause larger firms to produce goods and services at increased per-unit costs. • Two types: Internal diseconomies External diseconomies

Diseconomies of scale • There is a point of optimum capacity in all firms and industries. • If the firm grows beyond its scale of optimum capacity, it will experience an increase in average cost. • Thus, a firm attracts diseconomies of scale beyond the optimum capacity.

Internal diseconomies • Poor communication • Lack of motivation • Loss of direction and coordination

Poor communication • As firm expands, the one-on-one channels of communication grow more rapidly than the number of workers. • This increases cost and time of communication and leads to duplication of effort.

Lack of motivation • Workers feel isolated and less appreciated in a larger business • It is harder for managers to stay in dayto-day contact with workers and build up a good team environment and sense of belonging. • This leads to lower employee motivation with damaging consequences for output and quality

Loss of direction and coordination • Management becomes out of touch with the shop floor and some machinery becomes over-manned. • Decisions are not taken quickly • Accurate Information may not be available

External Diseconomies These occur when too many firms have located in one area. Unit costs begin to rise because: • Local labour becomes scarce and firms now have to offer higher wages to attract new workers. • Land and factories become scarce and rents begin to rise. • Local roads become congested and so transport costs begin to rise.

Summary:How the output changes due to addition of more inputs? Short Run Production Theory • Producer is interested in Returns to factor • 3 types-Increasing, Diminishing or negative returns to a factor • Causes-imperfect substitutability, judicious use of fixed factor, increase in

Long Run Production Theory • Producer is interested in Returns to scale • 3 types-Increasing, Constant, Diminishing returns to scale • Causes-Economies and diseconomies of scale

Economies of Scope • Economies of scope are present when the cost of joint output of a single firm is less than cost of output that could be achieved by two different firms when each produces a single product. • This implies that it is beneficial to the producer to produce and sell multiple products than a single

Economies of Scope • They arise because the firms can use a common input to make and sell more than one product. • For example, the Star Group, the Indian satellite Television company, can use the same satellite to broadcast a news channel, movie channel, sports channel and several entertainment

Economies of Scope • Another important source of economies of scope is marketing. • A company with a well established brand name in one product can introduce additional products at a lower cost than a stand-alone company will be able to. • Eg-Nike, Reebok, Adidas etc

Diseconomies of Scope • Diseconomies of scope are present when the cost of joint output of a single firm is greater than cost of output that could be achieved by two different firms when each produces a single product.

Key references for theory of Production

• Unit-3; Managerial Economics : SMU • Chapter- 6; Managerial Economics: Peterson & Lewis

Theory of Cost

Different types of Cost • Explicit cost • Implicit cost • Opportunity cost

Explicit Cost • Accounting Cost refers to the monetary expenses incurred in the production of a commodity. • It includes wages, rent, payments made for raw materials, payments into sinking funds and depreciation account. • It does not include implicit cost and opportunity cost.

Implicit cost • Those inputs which are used in production without purchase, or making any payment for their use. • Eg: Self owned land, self employed capital, owner acting as manager

Opportunity cost • It is the cost associated with opportunities that are foregone by not putting the firm’s resources to other alternatives. • It is the minimum price that is necessary to retain a factor service in its given use.

Cost function • It expresses the relationship between cost and its determinants. • C= f (S,O,P,T,….) where C is cost, S is size of plant O is level of output P is prices of inputs T is technology

Three Variants of Cost of Production • Total Cost • Average Cost • Marginal Cost All three of them are expressed as functions of output.

Total Cost • It is the sum of all expenses incurred by the producer in producing a given quantity of a commodity.

Average costs • Average costs are the total costs divided by the level of output • AC = TC/Q • It is the cost per unit of output produced. • It is a U shaped curve

Marginal cost • Marginal cost is the cost of producing one extra unit of output. MCn= TCn – TCn-1 It is a U – shaped curve

Cost Units of output 0

Total Cost

1

20

2

28

3

34

4

38

5

42

10

Average cost

Marginal cost

Cost function Time element has an important bearing on the cost and production of a commodity. • Short Run Cost Function-In the short run, distinction is made between fixed and variable costs. • Long Run Cost Function-In the long run, since all factors are variable, all costs are variable.

Cost Function Short Run Cost Function • Total Cost Total Fixed Costs Total Variable costs • Average Cost Average Fixed Cost Average Variable Cost • Marginal Cost

Long run cost Function • Long Run Total Cost • Long Run Average Cost • Long Run Marginal Cost

Short Run Cost Function • Total Cost-In the short run, total cost is sum of Total Fixed Costs and Total Variable costs • Total fixed Cost-Fixed costs are costs that do not change, whatever the level of output. • Total Variable costs are the costs that do change as the level of output changes.

Fixed or variable ? • Rent • Cost of raw material • Wages of casual labor • Wages of permanent staff • Expenses on electricity

Short Run Cost Function • TC =TFC+TVC • TC=TFC + f(Q) Eg TC=100 + 50Q TFC=? TVC=?

Total cost in short run Units of output 0

Fixed Cost Variable Cost

Total cost 10

1

20

2

28

3

34

4

38

5

42

Total cost in short run Units of output 0

Fixed Cost Variable Cost 10 0

Total cost

1

10

10

20

2

10

18

28

3

10

24

34

4

10

28

38

5

10

32

42

10

Average cost in short run • Average total cost in the short run is the sum of average fixed cost and average variable cost. • Average fixed cost is total fixed cost divided by output. • Average variable cost is total variable cost divided by output.

Average cost in short run • ATC = TFC+ TVC

Q

Q

• ATC= AFC+AVC Given TC = TFC + f(Q) AC= TC Q AFC=TFC Q AVC= f(Q) Q

Average Cost Units 0 1 2 3 4 5 6

TFC 10 10 10 10 10 10 10

TVC 0 10 18 24 28 32 38

TC

AFC

AVC

ATC

Question Given TC=2000 + 15Q • What is TFC at Q=2000? At Q=20000? • What is AFC at Q=2000? At Q=20000? • What is TVC at Q=20? • What is ATC at Q=20?

Average Fixed Cost • AFC falls as output increases. • As fixed cost is spread over larger quantities of output, fixed cost per unit of output becomes smaller and smaller. • Graphically, it is a downward sloping curve approaching the xaxis.

Average Variable Cost • AVC is a U-shaped curve. • It declines initially, but then rises as output is increased. • U-shape of the curve follows from the law of variable proportions.

Average cost • Average cost in both short and long run are U-shaped curves • Reasons for the shapes are different. • In the short run, law of variable proportions operates whereas in the long run economies and diseconomies of scale operate.

Key Reference for Theory of C Cost

• Unit-3 ; Managerial Economics : SMU • Chapter- 7; Managerial Economics: Peterson & Lewis