Page 138 - DECO405_MANAGERIAL_ECONOMICS

Unit 8: Cost Analysis

Managerial economics devotes a great deal of attention to the behaviour of costs. Total cost Notes
varies directly with output. The more output a firm produces, the higher will be its production
cost and vice versa. This is because increased production requires increased use of raw materials,
labour, etc., and if the increase is substantial even fixed inputs like plant and equipments and
managerial staff may have to be increased. The relationship between cost and output is rather
important.

Caselet Input Costs and Profit Levels of Maruti Udyog Ltd.
(MUL)

aruti currently dominates India's small car market and has a share of more than
80 per cent in its overall car market. MUL, a 50:50 joint venture between the
MIndian Government and Japan's Suzuki Motors Corporation posted net profit
of 6510 crores in 1997-98 (April-March) compared with 5,100 crores in the previous
year. But MUL could find it difficult to maintain its profit levels because of soaring input
costs and a slowdown in the market. Input costs had risen substantially due to the imposition
of a special additional duty, an increase in levies on cold rolled steel and a restriction on
reclaims of value-added tax to 95 per cent of the amount. Due to the slowdown in the
market and increasing competition, it will be very difficult to pass on the cost increase to
customers, thus, leading to a squeeze on margins.

8.5 Economies of Scale

A larger plant will lead to lower per unit cost in the long run. However, beyond some point,
successive larger plants will mean higher average costs. Exactly, why is the long run ATC curve
U-shaped, needs further explanation.

It must be emphasised, first of all, that the law of diminishing returns is not applicable here for
it presumes that one resource is fixed in supply and also that in the long run resource prices are
variable. Also, we assume that resource prices are constant in the short run. The U-shaped long
run average cost curve is explainable, thus, in terms of “economies and diseconomies” of large
scale production.
Economies and diseconomies of scale are concerned with the behaviour of average cost curve as
the plant size is increased. Economies of scale explain the down sloping part of the long run AC
curve. As the size of the plant increases, LAC typically declines over some range of output for a
number of reasons. The most important is that, as the scale of output is expanded, there is greater
potential for specialisation of productive factors. This is most notable with regard to labour but
may apply to other factors as well. Other factors contributing to declining LAC include ability
to use more advanced technologies and more sophisticated capital equipment, managerial
specialisation, opportunity to take advantage of lower costs for some inputs by purchasing
larger quantities, effective utilisation of by-products, etc.

But after sometime, expansion of a firm’s output may give rise to diseconomies, and therefore,
higher per unit cost. Further expansion of output beyond a reasonable level may lead to problems
of over crowding of labour, managerial inefficiencies, etc., pushing up per unit cost.
All these are examples of internal economies and diseconomies of scale arising due to the firm’s
own expansion. According to Marshall, external economies and diseconomies of scale may arise
due to the expansion of industry as a whole.

LOVELY PROFESSIONAL UNIVERSITY 133