Unit 3: Managerial Economics

Unit 3
Managerial Economics
Production
Production is a process of combining
various material inputs and immaterial
inputs (plans, know-how) in order to
make something for consumption
(output).
It is the act of creating an output, a good
or service which has value and contributes
to the utility of individuals
Production:
• Any activity leading to value addition
• Transformation of inputs into output
Production Function: a mathematical

expression or equation that explains the
relationship between a firm’s inputs and
its outputs:
Q= f (L,K)
Production Function
A production function is purely technical
relation which connects factor inputs &
outputs. It describes the transformation of
factor inputs into outputs at any particular time
period.
Q = f( L,K,R,Ld,T,t)
where
Q = output R= Raw Material
L= Labour Ld = Land
K= Capital T = Technology
t = time
For our current analysis, let’s reduce the inputs
to two, capital (K) and labor (L):
Q = f(L, K) 4
Production function is of two types:
(i) Linear homogeneous of the first degree in

which the output would change in exactly the
same proportion as the change in inputs.
Doubling the inputs would exactly double the
output, and vice versa. Such a production
function expresses constant returns to scale
(ii) Non-homogeneous production function of a

degree greater or less than one. The former
relates to increasing returns to scale and the
latter to decreasing returns to scale.
The short run is the period of time during
which at least some factors of production
are fixed.
The long run is the period of time during
which all factors are variable.
Fixed inputs are those that can’t easily be
increased or decreased in a short period of
time.
Variable inputs are those that can easily
be increased or decreased in a short period
of time.
 Production involves transformation of
inputs such as capital, equipment, labor,
and land into output - goods and
services
 Inthis production process, the manager
is concerned with efficiency in the use
of the inputs
- technical vs. economical efficiency
Two Concepts of Efficiency
Economic efficiency:
◦ occurs when the cost of producing a
given output is as low as possible
Technological efficiency:
◦ occurs when it is not possible to increase
output without increasing inputs
You will see that basic production theory
is simply an application of constrained
optimization:
Optimization: The action of making the best or most
effective use of a situation or resource.
the firm attempts either to minimize the cost of

producing a given level of output
or
to maximize the output attainable with a given
level of cost.
Both optimization problems lead to same rule for

the allocation of inputs and choice of technology
10
Total Product
The total product refers to the total amount (or volume) of
output produced with a given amount of input during a period
of time.
Average Product
The Average Product of an input is the Total Product divided by
the total amount of the variable input used to produce it.
AP = Total Product/ units of variable factor input = TP/L
Marginal Product
The Marginal Product of an input shows the increase in total
output from a one unit increase in the amount of the variable
input.
MP = Change in output/ Change in input (here, labour)

TP = ƩMP
Laws of Production:
Laws of Returns to Scale and Variable Proportions
The laws of production describe the technically possible

ways of increasing the level of production. Output may
increase in various ways.
Output can be increased by changing all factors of

production. Clearly this is possible only in the long run.
Thus the laws of returns to scale refer to the long-run
analysis of production.
In the short run output may be increased by using more

of the variable factor(s), while capital (and possibly
other factors as well) are kept constant.
Law of Variable Proportions or Returns to a Factor
This law exhibits the short-run production functions in

which one factor varies while the others are fixed.
If one input is variable and all other inputs are fixed the
firm’s production function exhibits the law of variable
proportions. If the number of units of a variable factor is
increased, keeping other factors constant, how output
changes is the concern of this law. Suppose land, plant
and equipment are the fixed factors, and labour the
variable factor.
When the number of labourers is increased successively

to have larger output, the proportion between fixed and
variable factors is altered and the law of variable
proportions sets in.
Law of Diminishing Returns or Law of Variable
Proportion
The law of variable proportion shows the production

function with one input factor variable while keeping the
other input factors constant. The law of variable
proportion states that, if one factor is used more and
more (variable), keeping the other factors constant, the
total output will increase at an increasing rate in the
beginning and then at a diminishing rate and eventually
decreases absolutely.
The law of variable proportion is also known as the

law of proportionality, the law of diminishing
returns, law of non-proportional outputs etc.
• Assumptions of the Law
The law of variable proportion is valid when the following
conditions are fulfilled:
The technology remains constant. If there is an

improvement in the technology, due to inventions,
the average and marginal product will increase
instead of decreasing.
Only one input factor is variable and other factor
are kept constant.
All the units of the variable factors are identical.
They are of the same size and quality.
A particular product can be produced under
varying proportions of the input combinations.
The law operates in the short run.
Application of Law of Diminishing
Returns:
It helps in identifying the rational and

irrational stages of operations.
It gives answers to question –
How much to produce?

What number of workers to apply to a
given fixed inputs so that the output is
maximum?
The Law of Returns to Scale:
The law of returns to scale describes the relationship

between outputs and scale of inputs in the long-run
when all the inputs are increased in the same
proportion. In the words of Prof. Roger Miller,
“Returns to scale refer to the relationship between
changes in output and proportionate changes in all
factors of production.
Assumptions:
This law assumes that:
(1) All factors (inputs) are variable but
enterprise is fixed.
(2) A worker works with given tools and
implements.
(3) Technological changes are absent.
(4) There is perfect competition.
(5) The product is measured in quantities.
Returns to scale relates to the behaviour of total
output as all inputs are varied and is a long run
concept”. Leibhafsky
Returns to scale are of the following three types:
1. Increasing Returns to scale.

2. Constant Returns to Scale
3. Diminishing Returns to Scale
Increasing Returns to Scale:
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.
Diminishing Returns to Scale:
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.
If 20 percent increase in labour and capital is
followed by 10 percent increase in output, then it is
an instance of diminishing returns to scale.
Constant Returns to Scale:
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.

Unit 3: Managerial Economics

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Unit 3

Production Function: a mathematical

(i) Linear homogeneous of the first degree in

(ii) Non-homogeneous production function of a

the firm attempts either to minimize the cost of

Both optimization problems lead to same rule for

MP = Change in output/ Change in input (here, labour)

The laws of production describe the technically possible

Output can be increased by changing all factors of

In the short run output may be increased by using more

This law exhibits the short-run production functions in

When the number of labourers is increased successively

The law of variable proportion shows the production

The law of variable proportion is also known as the

The technology remains constant. If there is an

It helps in identifying the rational and

How much to produce?

The law of returns to scale describes the relationship

Returns to scale are of the following three types:

1. Increasing Returns to scale.

Increasing returns to scale or diminishing

Diminishing returns or increasing costs refer to that

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