Managerial Economics

Causes of Returns to
scale
Increasing returns Diminishing returns
to scale to scale
Economies of scale Diseconomies of
-Internal economies scale
-External -Internal
economies 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 co-
ordination
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 day-
to-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 co-
ordination
• 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 Long Run Production
Theory Theory
• Producer is • Producer is
interested in Returns interested in
to factor Returns to scale
• 3 types-Increasing, • 3 types-Increasing,
Diminishing or Constant,
negative returns to a Diminishing returns
factor to scale
• Causes-imperfect • Causes-Economies
substitutability, and diseconomies
judicious use of fixed of scale
factor, increase in
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 Total Cost Average Marginal

output cost cost
0 10
1 20
2 28
3 34
4 38
5 42
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 Long run cost
Function Function
• Total Cost • Long Run Total
Total Fixed Costs Cost
Total Variable costs • Long Run Average
• Average Cost Cost
• Long Run
Average Fixed Cost
Marginal Cost
Average Variable
Cost
• 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 Fixed Cost Variable Total cost

output Cost
0 10
1 20
2 28
3 34
4 38
5 42
Total cost in short run

Units of Fixed Cost Variable Total cost

output Cost
0 10 0 10
1 10 10 20
2 10 18 28
3 10 24 34
4 10 28 38
5 10 32 42
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 TFC TVC TC AFC AVC ATC

0 10 0
1 10 10
2 10 18
3 10 24
4 10 28
5 10 32
6 10 38
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 x-
axis.
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