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1 SCHOOL OF HUMANITIES, MANAGEMENT AND SOCIAL SCIENCES
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SCHOOL OF HUMANITIES,
MANAGEMENT AND SOCIAL SCIENCES
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Mountain Top University
Kilometre 12, Lagos-Ibadan Expressway, MFM Prayer City, Ogun State.
PHONE: (+234)8053457707, (+234)7039395024, (+234) 8039505596
EMAIL: [email protected]
Website: www.mtu.edu.ng.
Published By:
Mountain Top University
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COURSE TITLE: Economics of Production
COURSE CODE: ECO 313
LECTURER(S): Adeniyi J. ADEDOKUN (Ph.D)
COURSE GUIDE
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GENERAL INTRODUCTION AND COURSE OBJECTIVES
This course aims at explaining the principles by which business firms optimize production
activities. It explains how businesses make optimal decisions on the choice of output and inputs
such as labour, capital and raw materials, among others. In summary, it deals with
maximization of outputs/revenue and/or minimization of inputs/expenditure. The course
requires foundational knowledge in microeconomics and mathematical economics.
COURSE OBJECTIVES
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COURSE CONTENTS
Lecture One: Review of Basic Concepts 6
Lecture Two: Cost Concepts and Characteristics 10
Lecture Three: Representation of Cost Concepts 13
Lecture Four: Cost Analysis and Economies of Scale 16
Lecture Five: External and Internal Economies and
Diseconomies of Scale 20
Lecture Six: Corporate Pricing Behaviour 22
Lecture Seven: Material Handling 24
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LECTURE ONE
REVIEW OF BASIC CONCEPTS
1.0 Introduction
This lecture focuses on basic concepts that will be useful in the subsequent lectures. The
starting point will be to treat some general concepts like production, production functions,
economic activities, Production Classification, factors of production, returns to scale, time
period for firms, and law of diminishing returns.
Objectives
At the end of this lecture, students should be able to:
1. explain in details the various concepts as stated above;
2. explain what an economic activity is; and
3. distinguish between what is production and what is not production.
Pre-Test
1. Define production
2. What is the difference between a function and an equation?
3. What do you understand by the phrase ‘economic activity’?
CONTENT
1.1 Production
According to Bates and Parkinson, “Production is the organised activity of transforming
resources into finished products in the form of goods and services; the objective of production
is to satisfy the demand for such transformed resources”. Also, J. R. Hicks defined as any
activity directed to the satisfaction of other peoples’ wants through exchange”. This definition
makes it clear that, in economics, we do not treat the mere making of things as production.
What is made must be designed to satisfy wants.
1.2 What is not Production?
The making of things which are not needed or without any usefulness does not qualify as
production. However, all activities such hair-dressing, soliciting, banking, and so on, aim at
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satisfying wants are part of production. Thus, the test of whether or not any activity is
productive is whether or not anyone will demand its end-product.
1.3 Economic Activities
Economic activity is any activity which utilizes scarce resources for the purpose of creating
income. Therefore, until an activity is exchanged to earn income, it is not an economic activity.
For instance, a farmer who sells his products in the market in exchange for money is engaged
in economic activity while a mechanic who repairs his own car or cuts the grasses of his garden
by himself is not engaged in economic activities.
1.4 Production Classification
i. Primary Production
This entails extracting the gifts of Nature from the earth’s surface, from beneath the earth’s
surface and from the oceans. Primary production is carried out by ‘extractive industries’ such
as agriculture, forestry, fishing, petroleum and mining.
ii. Secondary Production
This entails converting raw materials and intermediate goods into semi-finished and finished
goods. For example, conversion of flour into bread or iron ore into steel.
iii. Tertiary Production
This is the provision of services such banking, insurance, transport and communications, and
so on.
1.5 Factors of Production
Classification of Factors of Production:
Table 1.1: Classification of factors of production
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1.6 Economics of production
Economics of production can be defined as principles by which business firms optimize
production activities. It explains how businesses make optimal decisions on the choice of
output and inputs such as labour, capital and raw materials, among others. In summary, it deals
with maximization of outputs/revenue and/or minimization of inputs/expenditure.
1.7 Why study production economics?
To determine optimum production level where cost is minimized and revenue is maximized.
1.8 Production functions
Production function expresses the relationship between the output and inputs. It states the
amount of product that can be obtained from each and every combination of factor inputs. This
relationship can be written mathematically as
Q = f (x1, x2, . . . , xn; y1, y2, . . . , ym)
where Q represents output, x represents variable inputs, and y represents fixed inputs.
Embedded in the production function is the technology used in production. These technology
is explained by returns to scale principle.
1.9 Returns to Scale
There are 3 types of returns to scale
i. Constant returns to Scale
ii. Increasing returns to scale, and
iii. Decreasing returns to scale.
1.10 Time periods for the firm
The fundamental principles of production relate closely to the time periods in question, of
which there are four.
i. The very short run
A firm is in its very short run when the only way to increase output is by using up existing
stocks of inputs.
ii. The short run
A firm is in its short run when it can increase its output by increasing its variable factors, such
as labour, but not by increasing its fixed factors such as machinery.
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iii. The long run
A firm is in its long run when it increases its scale of operations. This means that all factors of
production are variable.
iv. The very long run
An industry enters the very long run when there is a significant change in the use of technology.
Note that economic analysis focus more on the short and long run analyses.
1.11 The law of diminishing returns
The law of diminishing marginal returns is applicable whenever a firm tries to increase output
by applying additional variable inputs to a fixed input. It states that assuming one factor is
fixed, the marginal returns generated from adding new variable factors will not be constant. It
will rise at first, reach a maximum point, and then eventually diminish.
Post-Test
1. With examples, what do you understand by production activity and non-production
activity?
2. Explain the four factors of production.
3. An economic activity is whatever an individual spends time on. True or false?
4. Differentiate among the various time periods for the firm.
Bibliography
- Doll P. John and Orazem Frank , Production Economics , John Wiley &Sons, Inc , USA
- Production and Cost Analysis: Part II, Chapter 10, www2.gsu.edu/~ecorlcx/Colander-
ch10-Production&CostsII.ppt
- Tutor2u Economics, Returns to Scale,
https://www.tutor2u.net/economics/reference/returns-to-scale
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LECTURE TWO
COST CONCEPTS AND CHARACTERISTICS
2.0 Introduction
This lecture focuses on cost concepts and the characteristics of the costs. Fundamentally, it is
important to note that economic efficiency of any firm is determined by its ability to minimize
costs and maximize profits. Also. It is important to know that cost is a function of Output. As
output of a firm changes the cost pattern also undergoes change.
Objectives
At the end of this lecture, students should be able to:
1. identify various cost concepts and their characteristics; and
2. identify the core or major production costs in economics.
Pre-Test
1. Define opportunity cost.
2. Explain the various production costs you know.
CONTENT
2.1 Opportunity Cost
The opportunity cost of a company is its alternative forgone.
2.2 Money Cost Vs Real Cost
Money Cost is the actual monetary expenditure made by company in the production process.
Real Cost includes all expenses/costs of business which may or may not involve actual
monetary expenditure.
2.3 Accounting Cost Vs Economic Cost
Accounting Cost includes all business expenses that are recorded in the book of accounts. Such
expenses include Cost of Raw Materials, Wages and Salaries, Direct and Indirect business
Overheads, Depreciation, and so on. When accounting expenses are deducted from Sales
income, the remainder is the accounting profit. Such Accounting costs are also termed
as Explicit Costs.
Economic Cost on the other hand includes all accounting expenses plus opportunity cost.
Given the accounting cost, economic cost and economic profit are calculated as follows:
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Economic Cost = Accounting Cost (Explicit Costs) + Opportunity Cost
Economic Profit = Total Revenues - (Accounting Cost + Opportunity Cost)
2.4 Private Cost Vs Social Cost
The actual expenses of individual/firm which are borne or paid by the individual/firm is
referred to as Private Cost. However, Social Cost includes Private Cost plus costs which are
not borne by the private entity, either individual or firm, but by the society at large; this includes
external cost.
2.5 Core Production Costs
Fixed Cost, Variable Cost, Total Cost, Average Cost and Marginal Cost
Fixed Cost is that cost which does not change with the level of production. It is irresponsive to
production levels.
Variable Cost is directly proportional to the production operations. It grows as production
grows, and vice versa.
Total Cost is the addition of fixed cost and variable cost.
Average Cost is defined as cost per unit of output. That is, total cost divided by units of good
produced
Marginal Cost is the change in the Total cost due to an additional unit of good is produced. In
other words Marginal Cost is difference between total Cost of producing ‘N + 1’ units of good
and ‘N’ units of good.
Post-Test
1. Explain fixed cost, variable cost, total cost, average cost, and marginal cost.
2. Differentiate between the following:
Private cost and social cost
Money cost and real cost
Accounting cost and economic cost
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Bibliography
- Doll P. John and Orazem Frank , Production Economics , John Wiley &Sons, Inc , USA
- Production and Cost Analysis: Part II, Chapter 10, www2.gsu.edu/~ecorlcx/Colander-
ch10-Production&CostsII.ppt
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LECTURE THREE
REPRESENTATION OF COST CONCEPTS
3.0 Introduction
This lecture focuses on cost concepts representation. Thus, it explains cost in details using
algebra and graph.
Objectives
At the end of this lecture, students should be able to:
3. identify and draw graphs of various costs; and
4. identify and explain mathematical representation of various costs.
Pre-Test
3. What is cost function?
4. Differentiate between variable cost and total cost curves.
CONTENT
3.1 Cost Function
Cost function shows the relationship between cost and output. The cost is presented at the left
hand side of the equation, where quantity of output produced is presented on the right hand
side of the equation. For example, a total cost function can be written as
TC = 50 + 3Q (1)
where TC is the total cost and Q is the level of quantity of output produced.
3.2 Algebraic Representation of Cost
Total Cost
This represent the total cost of production. It is the addition of variable cost and fixed cost.
Example of a typical total cost function is
TC = 0.1Q3 - 4Q2 + 80Q + 150 (2)
Fixed Cost
This is the part of the total cost that do not vary with the level of output. Fixed cost is always
fixed. It is positive and fixed even at zero quantity of output. The fixed cost is 150 in equation
(2).
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Variable Cost
Variable cost varies positively with output. Variable costs are represented in equation (2) by
0.1Q3 - 4Q2 + 80Q
Marginal Cost
Marginal cost (MC) is the differential of TC with respect to Q. Thus, from equation (2) MC is
0.3Q2 - 8Q + 80
Average Cost
Average cost is the same as average total cost measured as total cost divided by output. From
equation (2), Average cost is 0.1Q2 - 4Q1 + 80 + 150Q-1
Average Variable Cost
Average variable cost (AVC) is measured as variable cost divided by output. For example,
AVC will be 0.1Q2 - 4Q1 + 80
Average Fixed Cost
Average fixed cost (AFC) is measured as fixed cost divided by output. For example, AFC will
be 150Q-1
3.3 Graphical Representation of Cost
The graph below presents marginal cost and various costs in their averages.
Figure 3.1: Graphical Representation of Cost
The following are characteristics of the above graph.
i. The vertical axis measures the cost in naira value (P).
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ii. The horizontal axis measures output (Q).
iii. AFC decreases with output.
iv. AVC comes closer to ATC as output increases because of decrease in AFC.
v. MC curve intersects the ATC and AVC at their minimum points.
vi. MC is lower than AVC before the point of intersection but higher after it.
Post-Test
1. Draw the graphs of average fixed cost, average variable cost, average total cost, and
marginal cost.
2. Explain the relationship between the following:
i. Marginal cost curve and average variable cost curve
ii. Average fixed curve and output
Bibliography
- Doll P. John and Orazem Frank , Production Economics , John Wiley &Sons, Inc , USA
- Production and Cost Analysis: Part II, Chapter 10, www2.gsu.edu/~ecorlcx/Colander-
ch10-Production&CostsII.ppt
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LECTURE FOUR
COST ANALYSIS AND ECONOMIES OF SCALE
4.0 Introduction
This lecture focuses on cost analysis and economies of scale. It shows the behavior of total cost
when there is economies and/or diseconomies of scale.
Objectives
At the end of this lecture, students should be able to:
1. explain the concepts of economies and diseconomies of scale.
Pre-Test
1. Define economies of scale.
2. Define diseconomies of scale.
CONTENT
4.1 Economies of Scale
Economies of scale are the cost advantages that enterprises obtain due to their scale of
operation with cost per unit of output decreasing with increasing scale. Economies of scale
apply to a variety of organizational and business situations and at various levels, such as a
business or manufacturing unit, plant or an entire enterprise. Basically, economies of scale is
experienced when average costs start falling as output increases. On the other hand, firms can
become too large and suffer from diseconomies of scale.
Economies of scale arise because of the inverse relationship between the quantity
produced and per-unit fixed costs; i.e. the greater the quantity of a good produced, the lower
the per-unit fixed cost because these costs are spread out over a larger number of goods.
Economies of scale may also reduce variable cost per unit because of operational
efficiencies and synergies.
4.2 Total cost when there is economies of scale
Particularly, economies of scale describe the situation when the total costs rise less than
increase in production. This is presented in the following diagram:
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Figure 4.1: Economies of Scale
The curve above shows that total cost increases lower than the increase in output.
4.3 Total Cost when there is diseconomies of scale
Diseconomies of scale is the opposite case of economies of scale. The graph is shown below
Figure 4.2: Diseconomies of Scale
4.4 Long-run Cost
The firm’s long run average cost shows what is happening to average cost when the firm
expands, and is at a tangent to the series of short run average cost curves. Each short run average
cost curve relates to a separate stage or phase of expansion.
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Figure 4.3: Long-run average cost curve
The long run cost curve for most firms is assumed to be ‘U’ shaped, because of the impact
of internal economies and diseconomies of scale. However, economic theory suggests that
average costs will eventually rise because of diseconomies of scale.
Figure 4.4: Impact of economies and diseconomies of scale.
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Falling long run costs
Some firms may experience a continuous fall in long run average costs. These may become
natural monopolies.
Figure 5.1: Continuous falling average costs
Post-Test
1. What are the factors that can cause economic of scale?
2. With the aid of diagram, differentiate between economies of scale and diseconomies of
scale.
Bibliography
- Doll P. John and Orazem Frank , Production Economics , John Wiley &Sons, Inc , USA
- Production and Cost Analysis: Part II, Chapter 10, www2.gsu.edu/~ecorlcx/Colander-
ch10-Production&CostsII.ppt
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LECTURE FIVE
EXTERNAL AND INTERNAL ECONOMIES AND DISECONOMIES OF SCALE
5.0 Introduction
Having known what economies and diseconomies of scale are in the previous lecture, this
lecture focuses on explaining external and internal economies and diseconomies of scale.
Objectives
At the end of this lecture, students should be able to:
1. explain external and internal economies and diseconomies of scale; and
2. explain several factors that cause external and internal economies and diseconomies of
scale.
Pre-Test
1. Define external and internal economies of scale.
2. Define external and internal diseconomies of scale.
CONTENT
5.1 External economies of Scale
External economies (positive externalities) of scale are the benefits associated with the
expansion of a whole industry and result from external factors over which a single firm has
little or no control.
Causes of External economies of scale
i. Research and Development
ii. Localization of the industry
iii. Specialization
iv. Technology
v. Tax
5.2 External Diseconomies of Scale
External diseconomies (negative externalities) of scale are the costs associated with the
expansion of a whole industry and result from external factors over which a single firm has
little or no control.
Causes of External Diseconomies of scale
i. Localization e.g. pollution, excessive strain on transport infrastructure, competition.
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5.3 Internal Economies of Scale
Internal economies of scale is associated with the benefits from the expansion of a single firm.
Causes of internal economies of scale
i. Technical economies
ii. Purchasing economies
iii. Administrative savings
iv. financial savings
v. Risk bearing economies
5.4 Internal Diseconomies of Scale
Economic theory also predicts that a single firm may become less efficient if it becomes too
large. The additional costs of becoming too large are called diseconomies of scale.
Causes of internal diseconomies of scale
i. Poor communication
ii. Co-ordination problems
iii. Low motivation
iv. Principal-agent problem
Post-Test
1. With illustrations, explain four factors that cause internal diseconomies of scale.
2. Highlight three factors that cause external economies of scale.
Bibliography
- Doll P. John and Orazem Frank , Production Economics , John Wiley &Sons, Inc , USA
- Disseconomies of Scale of Production: Internal and External.
http://www.economicsdiscussion.net/production/diseconomies-of-scale-of-production-
internal-and-external/6912
- Diseconomies of Scale. https://www.economicshelp.org/microessays/costs/diseconomies-
scale/
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LECTURE SIX
CORPORATE PRICING BEHAVIOUR
6.0 Introduction
This lecture focuses on corporate pricing behavior. It explains some essential factors
considered by firms in fixing prices for their products.
Objectives
At the end of this lecture, students should be able to:
3. explain pricing policy; and
4. explain key pricing strategies.
Pre-Test
3. Define pricing policy.
4. Explain three key pricing strategies.
CONTENT
6.1 Price Policy
Price policy is one of the most important decisions in management as it affects corporate
profitability and market competitiveness. Price is one of the most flexible elements of the
marketing mix, which interferes directly and in a short term over the profitability and cost
effectiveness of a company.
Strategic pricing requires a stronger relationship between marketing and the other
sectors of a company. According to Monroe (2003), price decisions are one of the most
important decisions of management because it affects profitability and the companies’ return
along with their market competitiveness.
Companies which do not manage their prices lose control over them, impairing their
profitability and cost effectiveness mainly due to the customers will on paying a determinate
price, which not only does it depend on the perceived value, but also depends on the prices set
by the leading competitors.
Fundamentally, pricing in economics is determined by the market. That is, by the forces
of demand and supply. As the producers’ consideration of cost of production is important for
pricing, so also the consumers’ ability and willingness to pay. Sometimes the nature of a
product determines pricing. The elasticity nature (elastic, inelastic, perfectly elastic, perfectly
inelastic, unit elastic of a good can determine how pricing is done.
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4.2. Three Key Pricing Strategies
i. Customer value-based pricing strategy
Perceived value-based pricing is a pricing practice in which the managers take
decisions based on the perception of benefits from the item being offered to the
customer and how these benefits are perceived and weighted by the customers in
relationship to the price they pay. Therefore, as a cultural orientation of businesses,
value-based pricing is derived from a set of routine philosophies and organizational
strategies that a specific company could use in order to focus on customer
satisfaction and, as a result, increases their profitability.
ii. Competition-based pricing strategy
Competition-based pricing uses as key information the competitors’ price levels, as
well as behavior expectations, observed in real competitors and/or potential primary
sources to determine adequate pricing levels
iii. Cost-based pricing strategy
Cost-based pricing is the most simple and popular method for setting prices.
Historically, it is the most common pricing strategy because it carries a sense of
financial prudence. This involves adding a profit margin on costs, such as adding a
standard percentage contribution margin to the products and services.
Post-Test
1. Differentiate between customer value-based pricing strategy and cost-based pricing
strategy
2. Highlight three factors that can interfere with a cost-based pricing strategy
Bibliography
- Doll P. John and Orazem Frank , Production Economics , John Wiley &Sons, Inc , USA
- 3 Major Pricing Strategies. https://marketing-insider.eu/marketing-explained/part-iii-
designing-a-customer-driven-marketing-strategy-and-mix/pricing-strategies-and-
considerations/3-major-pricing-strategies/
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LECTURE SEVEN
MATERIAL HANDLING
7.0 Introduction
Material handling can be defined as an integrated system involving such activities as moving,
handling, storing and controlling of materials by means of gravity, manual effort or power
activated machinery. Moving materials utilize time and space. Any movement of materials
requires that the size, shape, weight and condition of the material, as well as the path and
frequency of the move be analyzed.
Objectives
At the end of this lecture, students should be able to:
1. define material handling;
2. know the objectives of material handling; and
3. know the key principles of material handling.
Pre-Test
1. Define material handling.
2. List 10 key principles of material handling.
CONTENT
7.1 Definition
There are many ways by which material handling has been defined but one simple definition
is “Material handling is the movement and storage of material at the lowest possible cost
through the use of proper method and equipment”.
Other definitions are:
“Material handling embraces all of the basic operations involved in the movement of
bulk, packaged, and individual products in a semisolid or solid state by means of
machinery, and within limits of a place of business”.
“Material handling is the art and science of moving, storing, protecting, and controlling
material”
“Material handling is the preparation, placing, and positioning of materials to facilitate
their movement or storage”.
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7.2 Objectives of Material Handling
The primary objective of a material handling system is to reduce the unit cost of production.
The other subordinate objectives are:
1. Reduce manufacturing cycle time
2. Reduce delays, and damage
3. Promote safety and improve working conditions
4. Maintain or improve product quality
5. Promote productivity
i. Material should flow in a straight line
ii. Material should move as short a distance as possible
iii. Use gravity
iv. Move more material at one time
v. Automate material handling
6. Promote increased use of facilities
i. Promote the use of building cube
ii. Purchase versatile equipment
iii. Develop a preventive maintenance program
iv. Maximize the equipment utilization etc.
7. Reduce tare weight
8. Control inventory
KEY TEN PRINCIPLES OF MATERIAL HANDLINGS
The material handling principles provide fundamentals of material handling practices and
provide guidance to material handling system designers. The following is a brief description
of material handling principles.
1. Planning principle All material handling should be the result of a deliberate plan where
the needs, performance objectives and functional specification of the proposed methods are
completely defined at the outset. In its simplest form a material handing plan defines the
material (what) and the moves (when and where); together they define the method (how and
who).
2. Standardization principle Standardize handling methods and equipments wherever
possible. Material handling methods, equipment, controls and software should be standardized
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within the limits of achieving overall performance objectives and without sacrificing needed
flexibility, modularity and throughout anticipation of changing future requirements.
3. Work Principle: Material handling work should be minimized without sacrificing
productivity or the level of service required of the operation. The measure of work is material
handling flow (volume, weight or count per unit of time) multiplied by the distance moved.
Simplifying processes by reducing, combining, shortening or eliminating unnecessary moves
will reduce work.
4. Ergonomic principle Human capabilities and limitations must be recognized and respected
in the design of material handling tasks and equipment to ensure safe and effective operations.
Equipments should be selected that eliminates repetitive and strenuous manual labor and which
effectively interacts with human operators and users.
5. Unit load principle A unit load is one that can be stored or moved as a single entity at one
time, such as a pallet, container or tote, regardless of the number of individual items that make
up the load. Unit loads shall be appropriately sized and configured in a way which achieves the
material flow and inventory objectives at each stage in the supply chain.
6. Space utilization principle Effective and efficient use must be made of all available space.
In work areas, cluttered and unorganized spaces and blocked aisles should be eliminated. When
transporting loads within a facility, the use of overhead space should be considered as an
option.
7. System principle Material movement and storage activities should be fully integrated to
form a coordinated, operational system which spans receiving, inspection, storage, production,
assembly, packaging, unitizing, order selection, shipping, transportation and the handling of
returns. Systems integration should encompass the entire supply chain including reverse
logistics. It should include suppliers, manufacturers, distributors and customers.
8. Automation principle Material handling operations should be mechanized and/or
automated where feasible to improve operational efficiency, increase responsiveness, and
improve consistency and predictability.
9. Environmental principle Environmental impact and energy consumption should be
considered as criteria when designing or selecting alternative equipment and material handling
systems.
10. Life cycle cost principle A thorough economic analysis should account for the entire life
cycle of all material handling equipment and resulting systems. Life cycle costs include capital
investment, installation, setup and equipment programming, training, system testing and
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acceptance, operating (labor, utilities, etc.), maintenance and repair, reuse value, and ultimate
disposal
Post-Test
1. What are the 10 key principles of material hanling?
2. Explain the objectives of material handling.
Bibliography
- Doll P. John and Orazem Frank , Production Economics , John Wiley &Sons, Inc , USA
