THE PRODUCTION THE PRODUCTION PROCESSPROCESS

Production is a process in which Production is a process in which economics resources or inputs are economics resources or inputs are

combined by entrepreneurs to combined by entrepreneurs to create economic goods and create economic goods and

servicesservices

THE PRODUCTION FUNCTIONTHE PRODUCTION FUNCTION

The task of a production unit is to The task of a production unit is to organise a production process – a organise a production process – a process of combining the different process of combining the different factors in some proportion so that factors in some proportion so that those inputs can be efficiently those inputs can be efficiently transformed into products or outputs. transformed into products or outputs.

The production functionThe production function

INPUTSINPUTS

FactorsFactors

Factors of Factors of productionproduction

Resources Resources

OUTPUTSOUTPUTS

Quantity (Q)Quantity (Q)

Total product(P)Total product(P)

ProductProduct

Mathematical statementsMathematical statements

Q=f(XQ=f(X11,X,X2 2 ...........................X...........................XKK)) Where Q=Output, XWhere Q=Output, X11 …………X …………X22 =Inputs used =Inputs used For the purpose of analysis, the equation can be reduced to two inputs X and For the purpose of analysis, the equation can be reduced to two inputs X and

Y.Y. Q=f(X,Y)Q=f(X,Y) Where Q=outputWhere Q=output X=LabourX=Labour Y=CapitalY=Capital

The production function defines the relationship The production function defines the relationship between inputs and the maximum amount that between inputs and the maximum amount that can be produced within a given period of time can be produced within a given period of time with a given level of tecnologywith a given level of tecnology

The Nature of productionThe Nature of production

1.1. The production function is purely The production function is purely technological.technological.

2.2. Production function is a continuous Production function is a continuous functionfunction

3.3. Production function has economic Production function has economic importanceimportance

4.4. Production functions differ from firm Production functions differ from firm to firm and industry to industryto firm and industry to industry

Nature of production function

Purely technological

Economic Importance

Continuous functionDiffer from firm to firm

Types of production functionTypes of production function

1.1. Fixed proportion and variable Fixed proportion and variable proportion production functionproportion production function

2.2. Short period and long period Short period and long period production function production function

3.3. Cobb-Douglas production function.Cobb-Douglas production function.

The fixed proportion production function

Variable proportion production function

a

b

c

100

200

300

Labour

C

a

p

i

t

a

l

ox1 x2 x

3

y1

y2y3

Production function throughProduction function through Iso-Quants analysis Iso-Quants analysis

Iso-Quant curveIso-Quant curve It is a concept which tells that the quantity It is a concept which tells that the quantity

produced will be same inspite of variation in produced will be same inspite of variation in production.production.

There may be different combination of inputs. Each There may be different combination of inputs. Each combination is called a scale of preference. Each combination is called a scale of preference. Each scale when applied will produce the same scale when applied will produce the same quantity of output. Thus, quantity of output. Thus,

” ”Iso-Quant” (which means equal quantity) curve Iso-Quant” (which means equal quantity) curve indicates that each curve will have different indicates that each curve will have different scales of preference of input which can produce scales of preference of input which can produce the same quantity of ouputthe same quantity of ouput

ILLUSTRATIONILLUSTRATION Two variables inputs namely capital (k) Two variables inputs namely capital (k)

and labour(l) are considered. Total output and labour(l) are considered. Total output is Rs 100 labour cost is Rs 10 per unit and is Rs 100 labour cost is Rs 10 per unit and capital cost is Rs 30 per unit some capital cost is Rs 30 per unit some alternative combinations are as follows: alternative combinations are as follows:

Combination Capital LabourCombination Capital Labour 1 3 11 3 1 2 2 42 2 4 3 1 73 1 7

Plotting the above cost combination Plotting the above cost combination we get the isocost line as followswe get the isocost line as follows

0 1 22 3 4 5 6 7 8

1

2

3

4

5

When outlay is increased prices of factors When outlay is increased prices of factors remaining unchanged, factor combination will remaining unchanged, factor combination will change with more quantities of factors being change with more quantities of factors being purchased. For each increase in total outlay the purchased. For each increase in total outlay the isocost lines will be different and shift upwards. isocost lines will be different and shift upwards. Prices of factors remaining unchanged the isocost Prices of factors remaining unchanged the isocost lines will have parallel shifts.lines will have parallel shifts.

Properties of isoquantsProperties of isoquants1 1 Isoquants are convex to origin: The slope of the isoquant Isoquants are convex to origin: The slope of the isoquant

measures, the marginal rate of technical substitution of measures, the marginal rate of technical substitution of one factor input(say labour) for other factor input(say one factor input(say labour) for other factor input(say capital).capital).

2 Isoquants are negative slope: This means that in order to 2 Isoquants are negative slope: This means that in order to maintain a given level of output when the amount of one maintain a given level of output when the amount of one factor input is increased other must be decreased.factor input is increased other must be decreased.

3 Isoquants never intersect each other: This is necessary 3 Isoquants never intersect each other: This is necessary because by definition each isoquant represents a specific because by definition each isoquant represents a specific quatum of output. Therefore if two isoquants intersect quatum of output. Therefore if two isoquants intersect each other it would involve logical contradiction as each other it would involve logical contradiction as particular isoquant at time may be representing a small as particular isoquant at time may be representing a small as well as a large quantity of output.well as a large quantity of output.

4 Isoquants never touch axis: Isoquants do not intercept either 4 Isoquants never touch axis: Isoquants do not intercept either axis because if it touches it would mean that output is axis because if it touches it would mean that output is possible by using single factor, but this is unrealistic.possible by using single factor, but this is unrealistic.

5 Sometimes isoquants are oval shape: One isoquant may have 5 Sometimes isoquants are oval shape: One isoquant may have positive upwards slope at its ends. When with relatively positive upwards slope at its ends. When with relatively small amount of factor realtive large amount of factor is small amount of factor realtive large amount of factor is combined marginal productivity of abundant tends to be combined marginal productivity of abundant tends to be negative and as such resulting in decline of total output. In negative and as such resulting in decline of total output. In such cases the end positions of curves are called such cases the end positions of curves are called uneconomical. uneconomical.

Marginal rate of technical Marginal rate of technical substitution (MRTS) substitution (MRTS)

The producers substitute are input in the place of The producers substitute are input in the place of other in the production process. The substituting other in the production process. The substituting of one input for another without changing the of one input for another without changing the level of output is called as marginal rate of level of output is called as marginal rate of technical substitution. The scope of isoquant is technical substitution. The scope of isoquant is measured in terms of MRTS. The MRTS of factor measured in terms of MRTS. The MRTS of factor x(labour) for a unit of factor (y) which can be x(labour) for a unit of factor (y) which can be subsituted or replaced for a unit of x without subsituted or replaced for a unit of x without changing the level of output. The terms of inputs changing the level of output. The terms of inputs (K) and labour (L).(K) and labour (L).

MRTS is similar to MRC marginal rate MRTS is similar to MRC marginal rate of substitution in indifference curve of substitution in indifference curve analysis MRTS dimnishes always.analysis MRTS dimnishes always.

EQUILIBRIUM OF THE FIRM EQUILIBRIUM OF THE FIRM CHOICE OF OPTIMAL CHOICE OF OPTIMAL

COMBINATION OF FACTORS COMBINATION OF FACTORS

A producer or a firm is said to be in equilibrium A producer or a firm is said to be in equilibrium when it is able to produce more output with when it is able to produce more output with given outlay and given factors of production. A given outlay and given factors of production. A rational producer may attain equilibrium either rational producer may attain equilibrium either by maxmising output for a given cost or by maxmising output for a given cost or minimising cost subject to a given level of minimising cost subject to a given level of output. In order to determine the producers output. In order to determine the producers equilibrium we should intergrate an isoquant equilibrium we should intergrate an isoquant map with isocost line.map with isocost line.

An isoquant is the locus of all combinations of two An isoquant is the locus of all combinations of two factors of production that yield same level of factors of production that yield same level of satisfaction. Isoquant map refers to a group of satisfaction. Isoquant map refers to a group of isoquants each representing different levels of isoquants each representing different levels of output. An isocost line represents various output. An isocost line represents various combinations of two inputs that may be combinations of two inputs that may be purchased for a given amount of expenditure.purchased for a given amount of expenditure.

Maximisation of output for a Maximisation of output for a given cost. given cost.

A rational producer will always try to maxmise his A rational producer will always try to maxmise his output for given cost. This can explained with the output for given cost. This can explained with the help of a diagram. Suppose the producers cost help of a diagram. Suppose the producers cost outlay is C and the prices of capital and labour outlay is C and the prices of capital and labour are ‘i’ and ‘w’ respectively. Subject to these cost are ‘i’ and ‘w’ respectively. Subject to these cost conditions the producer would attempt to attain conditions the producer would attempt to attain the maximum output level.the maximum output level.

OPTIMAL FACTOR OPTIMAL FACTOR COMBINATION TO MAXIMISE COMBINATION TO MAXIMISE

OUTPUT LEVEL.OUTPUT LEVEL.

X

Y

A

BO

IQ1 (1000)

IQ2 (2000)

IQ3 (3000)

l

Labour

C

A

P

I

T

A

L

E

Let AB in the figure represents given cost outlay .IQ1,IQ2,IQ3 Let AB in the figure represents given cost outlay .IQ1,IQ2,IQ3 are isoquants representing three different levels of output are isoquants representing three different levels of output

IQ3 level of output is not attainable because it is out of reach IQ3 level of output is not attainable because it is out of reach of producer .In fact any output level beyond isocost line AB of producer .In fact any output level beyond isocost line AB

is not attainable .The producer firm reaches equilibrium is not attainable .The producer firm reaches equilibrium position at point E at this stage he employs OK amount of position at point E at this stage he employs OK amount of

capital and OL of labour.capital and OL of labour.

The aim of producer is to maximize his output with given cost The aim of producer is to maximize his output with given cost outlay he will prefer only point E and not any other point on outlay he will prefer only point E and not any other point on

isocost line.isocost line.

Minimisation of cost for aMinimisation of cost for a given level of output given level of output

The producer or the firm may minimize the cost The producer or the firm may minimize the cost of producing a given amount of output. In both of producing a given amount of output. In both the cases the condition of equilibrium remains the cases the condition of equilibrium remains the same. That is the MRTS must be equal to the same. That is the MRTS must be equal to factor price ratio.factor price ratio.

MRTSMRTSLKLK=w/i=P=w/i=Pll/P/Pkk

Where, W=wages (price for labour)Where, W=wages (price for labour) i=interest (price for capital)i=interest (price for capital)

ppl l =Price of labour=Price of labour

ppkk=price of capital=price of capital

O L B1 B2 B3 X

LABOUR

Y

A3

A2

A1

K IQ (2000)

F

G

E

C

A

P

I

T

A

L

of isocost lines representing various levels of total cost of isocost lines representing various levels of total cost outlay (Aoutlay (A11BB11, A, A22BB22, A, A33BB33).The isocost lines Here , we have ).The isocost lines Here , we have one isoquant representing given level of output(i.e 2000 one isoquant representing given level of output(i.e 2000 units) and a set are parallel, and thus have the same scope units) and a set are parallel, and thus have the same scope because they have been drawn on the assumption of because they have been drawn on the assumption of constant price of factors.constant price of factors.

The iso-cost line,AB is not relevant because the output level The iso-cost line,AB is not relevant because the output level represent by the iso-quant IQrepresent by the iso-quant IQ22 (i.e. 2000units) is not (i.e. 2000units) is not producing by any factor combination ‘F’ and ‘G’ on Aproducing by any factor combination ‘F’ and ‘G’ on A33BB3 3

isocost line. But he can also produce the same level of isocost line. But he can also produce the same level of output at point ‘E’ (equilibrium) on Aoutput at point ‘E’ (equilibrium) on A22BB22 isocost line at a isocost line at a lower cost. Since the producer’s aim islower cost. Since the producer’s aim is to minimize the cost, to minimize the cost, he will choose the point ‘E’ rather than ‘F’ and ‘G’ because he will choose the point ‘E’ rather than ‘F’ and ‘G’ because these two points lie on the higher cost outlay. Therefore, these two points lie on the higher cost outlay. Therefore, the producer by employing OK of capital and OL of labour the producer by employing OK of capital and OL of labour can reach the equilibrium ‘E’ by minimizing the cost for a can reach the equilibrium ‘E’ by minimizing the cost for a stipulated output (2000 units).stipulated output (2000 units).

EXPANSION PATH: (Choice of optimal EXPANSION PATH: (Choice of optimal expansion path)expansion path)

When the financial resources of a firm increases, When the financial resources of a firm increases, it would like to increase its output. The output it would like to increase its output. The output can be increased if there is no increase in the can be increased if there is no increase in the cost of the factors. In other words, the output cost of the factors. In other words, the output produced by a firm increases with increase in produced by a firm increases with increase in its financial resources. By using different its financial resources. By using different combinations of factors(inputs) a firm can combinations of factors(inputs) a firm can produce different levels of output. Among produce different levels of output. Among these, the combination of factors which is these, the combination of factors which is optimum will be used by the firm and it is optimum will be used by the firm and it is called as “Expantion path”. It is also called as called as “Expantion path”. It is also called as ‘scale-line’ . According to Stonier and Hague ‘scale-line’ . According to Stonier and Hague “Expantion path is that line which reflects “Expantion path is that line which reflects least cost method of producing different levels least cost method of producing different levels of output”. of output”.

P

e1e2

e3

P

O B D G X

LABOUR

Y

F

C

A

KIQ3 (3000)

IQ2 (2000)

IQ3(1000)

Units of labour employed is measured along the X axis and capital Units of labour employed is measured along the X axis and capital employed is measured along the Y axis. The first iso-cost line of the employed is measured along the Y axis. The first iso-cost line of the

firm is AB. It is tangent to IQ at point ‘E’, which is the initial equilibrium firm is AB. It is tangent to IQ at point ‘E’, which is the initial equilibrium of the firm. Supposing the price per unit of labour and capital remains of the firm. Supposing the price per unit of labour and capital remains unchanged and the financial resources of the firm increases, the firm’s unchanged and the financial resources of the firm increases, the firm’s new iso-cost line shifts to right as CD. In this situation new iso-cost line new iso-cost line shifts to right as CD. In this situation new iso-cost line

CD will be parallel to the initial iso-cost line AB and tangent to IQCD will be parallel to the initial iso-cost line AB and tangent to IQ22 at at

point Epoint E22 which will be the new equilibrium point now. If the financial which will be the new equilibrium point now. If the financial

resources of the firm further increases, but the price of the factors resources of the firm further increases, but the price of the factors remaining the same, the iso-cost line will be FG. It will be tangent to remaining the same, the iso-cost line will be FG. It will be tangent to the iso-quant IQthe iso-quant IQ 3 3 at point Eat point E33 which will be the new equilibrium point which will be the new equilibrium point

of the firm. By joining all the equilibrium points we get a line(PP) called of the firm. By joining all the equilibrium points we get a line(PP) called scale-line or expansion path. It is called so because a firm expands its scale-line or expansion path. It is called so because a firm expands its

output or scale of production in conformity with this line. output or scale of production in conformity with this line.

COST MINIMISATIONCOST MINIMISATION

The firm wants to produces any amount The firm wants to produces any amount of output at the least cost. This is of output at the least cost. This is

obtained by point of tangency of the obtained by point of tangency of the isoquant to an ISO cost line. In other isoquant to an ISO cost line. In other

words, minimum cost mean that words, minimum cost mean that Isoquants are tangents to ISO cost Isoquants are tangents to ISO cost

lines.lines.

A

NM

L

B

O X1 D1 D2 D3 X

LABOUR

Y

C3

C2

C1

Y1

C

A

P

I

T

A

L

IQ3

IQ2

IQ3

In the above diagram the maximum output is In the above diagram the maximum output is obtained at a point of tangency between isoquant obtained at a point of tangency between isoquant

and ISO cost lines. N,M,L are the points of tangency. and ISO cost lines. N,M,L are the points of tangency. The firm expands output along the line D. At the The firm expands output along the line D. At the

point of N output, the firm buys OXpoint of N output, the firm buys OX || and OY and OY|| inputs. inputs. This is the optimal combination of inputs. At this This is the optimal combination of inputs. At this point, the marginal rate of substitution between point, the marginal rate of substitution between

inputs is equal to the ratio between the prices of the inputs is equal to the ratio between the prices of the inputs. The minimum cost represented by the point inputs. The minimum cost represented by the point

of tangency between the isoquant and ISO cost line.,of tangency between the isoquant and ISO cost line.,

Uses of production functionUses of production function

1.1. To know least-cost combination.To know least-cost combination.

2.2. To maxmise production.To maxmise production.

3.3. To attain equilibrium.To attain equilibrium.

4.4. Helps in decision making.Helps in decision making.

5.5. Basis for production planning.Basis for production planning.

Production function one variable input:Short run Production function one variable input:Short run analysis(Law of variable proportion)analysis(Law of variable proportion)

The law of variable proportion occupies very The law of variable proportion occupies very important place in ME because it examines the important place in ME because it examines the production function with one variable input keeping production function with one variable input keeping the other inputs fixed when quantities of one input the other inputs fixed when quantities of one input is varied keeping other inputs constant the is varied keeping other inputs constant the proportion between fixed factor and variable factor proportion between fixed factor and variable factor is altered when combination of inputs are thus is altered when combination of inputs are thus altered the resulting output changes .The effect of altered the resulting output changes .The effect of output of variations in factor proportions is called output of variations in factor proportions is called law of variable proportions. law of variable proportions.

The law states that “as more and more of factor The law states that “as more and more of factor input is employed all other input quantities input is employed all other input quantities remaning constant a point will eventually be remaning constant a point will eventually be reached where additional quantities of varying reached where additional quantities of varying input will yeild deminishing contributions to total input will yeild deminishing contributions to total products “.products “.

AssumptionsAssumptions1.1. The state of technology of production The state of technology of production

remains unchanged remains unchanged

2.2. Some inputs are kept fixed during the Some inputs are kept fixed during the process of production.It is only in this process of production.It is only in this

way that factors proportions are way that factors proportions are altered to know its effect on outputaltered to know its effect on output

3.3. The law is based on the possibility of The law is based on the possibility of varying proportion in which various varying proportion in which various

factors can be combined to produce a factors can be combined to produce a product.product.

Illustrations of lawIllustrations of law

No of No of workersworkers

(x) (x) output(o)output(o)

AverageAverage

productproduct

o/yo/y

MarginalMarginal

ProductProduct

StagesStages

11

22

33

88

1717

2727

88

8.58.5

99

88

99

1010

Increasing Increasing returns-Ireturns-I

44

55

66

77

3636

4343

4848

4848

99

8.68.6

88

6.86.8

99

77

55

00

DecreasinDecreasing returns-g returns-IIII

88 4646 5.75.7 -2-2 NegativeNegative

Returns-IIReturns-II

From total output average output can be From total output average output can be derived. Marginal product is the addition derived. Marginal product is the addition to total product which can be produced to total product which can be produced by addition of more units of variable by addition of more units of variable input. Average output is the ratio of total input. Average output is the ratio of total output to amount of variable input. The output to amount of variable input. The behaviour of the total average and behaviour of the total average and marginal output is shown in the diagram.marginal output is shown in the diagram.

Increasing returns stage:Increasing returns stage:

In this stage 1 total product increases at an In this stage 1 total product increases at an increasing rate. Two men produce more than twice as increasing rate. Two men produce more than twice as

one man. In this stage both marginal product (MP) one man. In this stage both marginal product (MP) and average product (AP) are rising. Because MP is and average product (AP) are rising. Because MP is

greater than AP MP pulls up the average product. The greater than AP MP pulls up the average product. The boundary line of 1 stage is reached when AP and MP boundary line of 1 stage is reached when AP and MP

are equal. This takes place at the point N in the are equal. This takes place at the point N in the diagram. The first stage is known as the stage of diagram. The first stage is known as the stage of increasing returns, because the AP of the variable increasing returns, because the AP of the variable

factor is increasing throughout the period. factor is increasing throughout the period.

Decreasing returns stageDecreasing returns stage

In the stage II,The total product contines to In the stage II,The total product contines to

increase,but at a diminishing rate. When the increase,but at a diminishing rate. When the marginal product is zero,the total product is the marginal product is zero,the total product is the maximum. In this stage both AP & MP are maximum. In this stage both AP & MP are declining. MP being below the average declining. MP being below the average product,pulls the agerage product down. At the product,pulls the agerage product down. At the end of the second stage at the poing M,the end of the second stage at the poing M,the marginal product to the variable product inputs marginal product to the variable product inputs become zero,while the total point reaches the become zero,while the total point reaches the heighest point. This stage is called the stage of heighest point. This stage is called the stage of deminishing returns as both the average and deminishing returns as both the average and marginal products of the variable factor marginal products of the variable factor continuously fall. continuously fall.

Negative returns stageNegative returns stage

In the stage III,total product declines and therefore the In the stage III,total product declines and therefore the total product curve slopes downword. As a result,the total product curve slopes downword. As a result,the marginal product is negative and the MP curve goes marginal product is negative and the MP curve goes below OX axis. The average product decreases still below OX axis. The average product decreases still further. It shows that the variable factor is toomuch further. It shows that the variable factor is toomuch to mixed factor. This stage is called the stage for to mixed factor. This stage is called the stage for negative returns.negative returns.

It may be noted that the stage I and III are It may be noted that the stage I and III are completely symmetrical. In the stage I,fixed factor is completely symmetrical. In the stage I,fixed factor is toomuch relative to the variable factor. In this stage toomuch relative to the variable factor. In this stage marginal product of the fixed factor is negative. On marginal product of the fixed factor is negative. On the other hand,in the stage III,variable factor is the other hand,in the stage III,variable factor is toomuch relative to the fixed factor. Therefore toomuch relative to the fixed factor. Therefore marginal product of the variable product is negative. marginal product of the variable product is negative.

The stage of operationThe stage of operationThe question is which stage of operation is rational to production. A The question is which stage of operation is rational to production. A

rational producer will not choose to produce in the stage III. At rational producer will not choose to produce in the stage III. At the end of stage II at the point M,the marginal product and thus the end of stage II at the point M,the marginal product and thus will be making the maximum use of the variable factor. In the will be making the maximum use of the variable factor. In the stage I,the producer will not be making maximum use of fixed stage I,the producer will not be making maximum use of fixed factor and he will not be utilising fully the opportunities of factor and he will not be utilising fully the opportunities of increasing production by increasing the quantity of variable increasing production by increasing the quantity of variable product,whose average product continues to raise throughout product,whose average product continues to raise throughout the stage I. Thus a rational producer will not stop in the stage the stage I. Thus a rational producer will not stop in the stage I,but will expand further. At point N the marginal product to the I,but will expand further. At point N the marginal product to the variable factor is the maximum and the end point N of the stage variable factor is the maximum and the end point N of the stage I,he will be making maximum use of the fixed factor. So long as I,he will be making maximum use of the fixed factor. So long as the average product,marginal product and total product are the average product,marginal product and total product are raising,the entrepreneur will not stop producing. Therefore he raising,the entrepreneur will not stop producing. Therefore he goes to stage II,where both marginal product and the average goes to stage II,where both marginal product and the average product of the variable factor are deminishing. The stage II product of the variable factor are deminishing. The stage II represents the range of rational production decisions.represents the range of rational production decisions.

The laws of returns to scale(Long run)The laws of returns to scale(Long run)

The laws production describe the technically The laws production describe the technically possible ways of increasing the level of possible ways of increasing the level of production. These show how the input can be production. These show how the input can be increased by changing the quantities of factor increased by changing the quantities of factor inputs. In the short run only one factor can be inputs. In the short run only one factor can be altered, keeping the other factor unchanged. It altered, keeping the other factor unchanged. It is because ,in the short period, fixed factors is because ,in the short period, fixed factors like machinery cannot be altered. But it is like machinery cannot be altered. But it is possible to alter the fixed factors in the long possible to alter the fixed factors in the long period. The laws of returns to the scale refers period. The laws of returns to the scale refers to the long run analysis of production. to the long run analysis of production.

The laws of returns to scale are entairly different from the laws The laws of returns to scale are entairly different from the laws of variable proportion. In the laws of returns to the scale,all of variable proportion. In the laws of returns to the scale,all

productive factors or inputs are increased or decreased in the productive factors or inputs are increased or decreased in the same proportion simeltaneously. In returns to scale,we analyses same proportion simeltaneously. In returns to scale,we analyses

the effect of doubling or tribling,quadrupling and so on of all the effect of doubling or tribling,quadrupling and so on of all inputs from the output of the product. The study of changes in inputs from the output of the product. The study of changes in

the output as a consequence of changes in the scale,forms the the output as a consequence of changes in the scale,forms the subject matter of ‘returns to scalesubject matter of ‘returns to scale’. ’.

The three phases of returns to scaleThe three phases of returns to scale

Producers who have not studied economic analysis Producers who have not studied economic analysis think that output can be doubled by doubling all the think that output can be doubled by doubling all the inputs or trible the output by tribling all the inputs or trible the output by tribling all the productive inputs. But actually this is not so. In other productive inputs. But actually this is not so. In other words,actually the output are returns donot words,actually the output are returns donot increase/decrease strictly according to the change in increase/decrease strictly according to the change in the scale.the scale.

If the increase in the output is proportional to If the increase in the output is proportional to increase in the quantities of input,returns to scale increase in the quantities of input,returns to scale are said to be constant. It means that a doubling of are said to be constant. It means that a doubling of inputs causes a doubling of output. If the increase in inputs causes a doubling of output. If the increase in output is more than the proportional,returns to scale output is more than the proportional,returns to scale are increasing and if the increase in output is less are increasing and if the increase in output is less than proportional,returns to scale to scale re than proportional,returns to scale to scale re deminishing. deminishing.

Returns to scaleReturns to scale

S.No.S.No. Scale of inputsScale of inputs Total Total productproduct

Marginal Marginal product product or or returnsreturns

StageStage

11

22

33

44

1 worker + 3 acres of land1 worker + 3 acres of land

2 workers + 6 acres of 2 workers + 6 acres of landland

3 workers + 9 acres of 3 workers + 9 acres of landland

4 workers + 12 acres4 workers + 12 acres

22

55

99

1414

22

33

44

55

Increasing Increasing returns-Ireturns-I

55

665 worker + 15 acres5 worker + 15 acres

6 worker + 18 acres6 worker + 18 acres1919

242455

55Constant Constant returns-IIreturns-II

77

88

99

7 worker + 21 acres7 worker + 21 acres

8 worker + 24 acres8 worker + 24 acres

9 worker + 27 acres9 worker + 27 acres

2828

3131

3333

44

33

22

Diminishing Diminishing returns-IIIreturns-III

Illustration Illustration

In the table,it can be sean that as all the factor inputs In the table,it can be sean that as all the factor inputs are together increased to the same extent,the are together increased to the same extent,the marginal product or returns increases first up to a marginal product or returns increases first up to a point then constant for some further increase in the point then constant for some further increase in the scale and ultimately starts declining. At the s.cale of 1 scale and ultimately starts declining. At the s.cale of 1 workers +30 acres of land,the total product is 2 workers +30 acres of land,the total product is 2 quintals. To increase the output,the scale is quintals. To increase the output,the scale is doubled,the total increases to more than double(5 doubled,the total increases to more than double(5 quintals instead of 2 quintals). When the output is quintals instead of 2 quintals). When the output is tribled,the output increaes to 9 quintals,the increase tribled,the output increaes to 9 quintals,the increase this time being 4 quintals instead of 3 quintals. In this time being 4 quintals instead of 3 quintals. In other words,the return to scale is increasing. If the other words,the return to scale is increasing. If the scale of production is further increased,the marginal scale of production is further increased,the marginal product remains constant upto a certain point and product remains constant upto a certain point and behyond it,it starts deminishing.behyond it,it starts deminishing.

Increasing returns to scaleIncreasing returns to scale

Increasing returns to scale means that output increases in a Increasing returns to scale means that output increases in a great proportion than increase in inputs.If for example all great proportion than increase in inputs.If for example all inputs are increased by 25 percent,the output increases by 40 inputs are increased by 25 percent,the output increases by 40 percent,then the increasing returns to scale is percent,then the increasing returns to scale is prevaililng.When the firm is expanding ,increasing returns to prevaililng.When the firm is expanding ,increasing returns to scale obtained in the beginning.One chief reason for this scale obtained in the beginning.One chief reason for this increase is the effect of technical and managerial increase is the effect of technical and managerial indivisibility.Indivisibility means that equipment is available indivisibility.Indivisibility means that equipment is available only in minimum sizes and the firm has to start producing only in minimum sizes and the firm has to start producing from the minimum size of equipment.In the beginning the firm from the minimum size of equipment.In the beginning the firm will not be in a position to use the equipment to its optimum will not be in a position to use the equipment to its optimum capacity.In other words ,the equipments are under-utilized in capacity.In other words ,the equipments are under-utilized in the beginning.When the scale of operations are the beginning.When the scale of operations are increased,they are input into maximum use and hence the increased,they are input into maximum use and hence the output are return increases more than proportiionately.output are return increases more than proportiionately.

0 1 2 3 4 5 6 7 8 9 10

Scale

6

5

4

3

2

1 M

arg

inal pro

duct

Stag

e I

Stage II

Stage III

Marginal products or returns

Constant returns to scaleConstant returns to scale

If the scale of inputs are increased in a given If the scale of inputs are increased in a given proportion and the output increases in the same proportion and the output increases in the same proportion,returns to scale are said to be proportion,returns to scale are said to be constant,that is doubling of all inputs,doubls the constant,that is doubling of all inputs,doubls the output. In mathematics the case of constant returns to output. In mathematics the case of constant returns to scale is called lenier and homogeneous production scale is called lenier and homogeneous production function or homogeneous production function of the function or homogeneous production function of the first degree. In some industries,expansion of output first degree. In some industries,expansion of output produces no net economies are diseconomies and the produces no net economies are diseconomies and the cost of production remains the same.cost of production remains the same.

Such industries said to be goverened by the law of Such industries said to be goverened by the law of constant returns.constant returns.

Diminishing returns to scaleDiminishing returns to scale

When the output increases in smaller proportion than When the output increases in smaller proportion than the increase in all inputs,decreasing returns to scale is the increase in all inputs,decreasing returns to scale is said to prevail. When firm goes on expanding by said to prevail. When firm goes on expanding by increasing all its inputs,then eventually diminishing increasing all its inputs,then eventually diminishing returns to scale occur.economists give different cause returns to scale occur.economists give different cause for diminishing returns some economists view that the for diminishing returns some economists view that the enterpreneur is one fixed,while all other inputs are enterpreneur is one fixed,while all other inputs are variable factors. But the enterpreneur factor cannot be variable factors. But the enterpreneur factor cannot be increased. On this view they say that the law of increased. On this view they say that the law of diminishing returns is the special case of the law of diminishing returns is the special case of the law of variable proportions. In this case they say that we get variable proportions. In this case they say that we get diminishing returns beyond a point,because varying diminishing returns beyond a point,because varying quantities of all other inputs are combined with the quantities of all other inputs are combined with the enterpreneur as a fixed factor. Other economists do not enterpreneur as a fixed factor. Other economists do not subscribe to this view but they say that diminishing subscribe to this view but they say that diminishing returns to scale occur because of increasing difficulties returns to scale occur because of increasing difficulties of management, coordination and control. When the of management, coordination and control. When the firm becomes gigantic, it is difficult to manage it with firm becomes gigantic, it is difficult to manage it with the efficiency as before.the efficiency as before.

Empirical production functionEmpirical production function

There are five types of linear and non-There are five types of linear and non-linear models of production linear models of production functions used in empirical studies.functions used in empirical studies.

► LINEAR PRODUCTION FUNCTION.LINEAR PRODUCTION FUNCTION.► QUADRATIC PRODUCTION FUNCTION.QUADRATIC PRODUCTION FUNCTION.► CUBIC PRODUCTION FUNCTION.CUBIC PRODUCTION FUNCTION.► POWER PRODUCTION FUNCTION.POWER PRODUCTION FUNCTION.► COBB DOUGLAS PRODUCTION COBB DOUGLAS PRODUCTION

FUNCTIONFUNCTION..

Linear production function.Linear production function.This is the simplest form of production This is the simplest form of production

function. In the short run it stated as function. In the short run it stated as follows:follows:

Q=bQ=b00+b+b11V WhereV Where

Q= OutputQ= Output

bb00=fixed factor input=fixed factor input

BB11= slope coefficient= slope coefficient

V = variable factorV = variable factor

Graphically the production function can Graphically the production function can be represented by a straight line be represented by a straight line

V

AP=MP

Q

The value of “bThe value of “b00” intercept parameter in the ” intercept parameter in the

shortrun production function refers to the fixed shortrun production function refers to the fixed factor input quantity “bfactor input quantity “b11’ the slope coefficient ’ the slope coefficient

represents the marginal product (MP) the represents the marginal product (MP) the variable factor. It being constant also variable factor. It being constant also

represents the average product (AP). As such represents the average product (AP). As such AP=MP when MP is constant, the marginal AP=MP when MP is constant, the marginal and average product curves are horizontal and average product curves are horizontal

straight lines, which tend to coincide.straight lines, which tend to coincide.

Quadratic production functionQuadratic production function It is stated as followsIt is stated as follows

Q=bQ=b00+b+b11V-bV-b22VV22

This equation measures downward slope of the AP This equation measures downward slope of the AP and MP curves as shown below. It is useful to know and MP curves as shown below. It is useful to know the quantum diminishing returns.the quantum diminishing returns.

Q

V

AP

MP

Cubic production functionCubic production function

It is stated as follows It is stated as follows

Q=bQ=b00+b+b11V+bV+b22VV22-b-b33VV33

This function highlights the law of non proportional returns to This function highlights the law of non proportional returns to the variable factors. Graphically it shows that the marginal the variable factors. Graphically it shows that the marginal product(MP) curve is initially raising and then falling. Also product(MP) curve is initially raising and then falling. Also the MP curve intersects the AP curve at its maximum pointthe MP curve intersects the AP curve at its maximum point..

Power production functionPower production functionIt is stated as followsIt is stated as follows

Q=aVQ=aVbb

where Q=the outputwhere Q=the output

a=constant parametera=constant parameter

b=powerb=power

V=variable factor inputV=variable factor input

Logarithmically, its linear form is as followsLogarithmically, its linear form is as follows

log(Q) = log(aVlog(Q) = log(aV b b))

log Q = log a + log (Vlog Q = log a + log (Vbb))

log Q = log a + b log V log Q = log a + b log V

Cobb-Douglas production functionCobb-Douglas production function

All the above stated production considered a All the above stated production considered a single variable factor at a time. The Cobb-single variable factor at a time. The Cobb-Douglas production function considers two Douglas production function considers two variables factor inputs. The Cobb-Douglas variables factor inputs. The Cobb-Douglas functional form of production function is functional form of production function is widely used to represent the relationship of widely used to represent the relationship of output to inputs. For production the function output to inputs. For production the function is is

Y=ALY=ALααkkββ

Where Y=Output, L=Labour input, K=Capital Where Y=Output, L=Labour input, K=Capital inputinput

A,A,αα,,ββ =Constant determined by technology. =Constant determined by technology.

If If αα++ββ =1 the production function has constant =1 the production function has constant returns to scale. That is if L and K are each increased returns to scale. That is if L and K are each increased by 20% Y increases by 20%.by 20% Y increases by 20%.

If If αα++ββ <1 the returns to scale are decreasing. <1 the returns to scale are decreasing. If If αα++ββ >1 the returns to scale are increasing. >1 the returns to scale are increasing.

Assuming perfect competition a and can be shown Assuming perfect competition a and can be shown to be labours and capital’s share of output.to be labours and capital’s share of output.

The exponents a and are output elasticities with The exponents a and are output elasticities with respect to labour and capital respectively. Output respect to labour and capital respectively. Output elasticity measures the responsiveness of output to elasticity measures the responsiveness of output to a change on labour or capital used in production, a change on labour or capital used in production, other things remaining equal. For example if a=1.5 a other things remaining equal. For example if a=1.5 a 1% increase in labour would lead to approximately a 1% increase in labour would lead to approximately a 1.5% increase in output.1.5% increase in output.

Cobb and Douglas were influenced by statistical Cobb and Douglas were influenced by statistical evidence that appeared to show that the labour and evidence that appeared to show that the labour and capital share of output were constant over a period capital share of output were constant over a period time in developed countries they explained this by time in developed countries they explained this by statistical fitting least squares regression of their statistical fitting least squares regression of their production function. Its transformation into linear form production function. Its transformation into linear form by using logarithms is as follows:by using logarithms is as follows:

Log A+Log A+ααLog L+Log L+ββLog K.Log K. The common form of Cobb Douglas function used in The common form of Cobb Douglas function used in

Macro economic modeling isMacro economic modeling is Y=KY=Kαα LL 1- 1- ββ where K is capital and L is labour. When the where K is capital and L is labour. When the

model coefficient sum to one as above, the production model coefficient sum to one as above, the production function is first order homogenous, which implies function is first order homogenous, which implies returns to scale that is if all the inputs are doubled the returns to scale that is if all the inputs are doubled the output is doubled.output is doubled.

In the Cobb Douglas function, elasticity of substitution In the Cobb Douglas function, elasticity of substitution between capital and labour that is capital can be between capital and labour that is capital can be interchanged with labour without affecting output. interchanged with labour without affecting output.

CES PRODUCTION FUNCTIONCES PRODUCTION FUNCTION

Proposed by American economist Kenneth and Arrow Proposed by American economist Kenneth and Arrow CES production function is also known as constant CES production function is also known as constant elasticity of substitution production function.This is a elasticity of substitution production function.This is a linear homogenous production function with constant linear homogenous production function with constant elasticity of input substitution which takes on the form elasticity of input substitution which takes on the form other than unity.other than unity.

It is replaced the cobb Douglas production function It is replaced the cobb Douglas production function model which looked at physical output as a product of model which looked at physical output as a product of labour and capital inputslabour and capital inputs

The equation for CES production function model isThe equation for CES production function model is

Q=A(aKQ=A(aK-b-b+(1-c)L+(1-c)L-b-b))-1/b -1/b

Where Q=output ,K=capital ,L=labourWhere Q=output ,K=capital ,L=labour

a,b,c, are constantsa,b,c, are constants

PRODUCTION POSSIBLITY PRODUCTION POSSIBLITY CURVECURVE

An economy has a certain population and An economy has a certain population and some millon workers of various grades, it some millon workers of various grades, it has mastered certain techniques of has mastered certain techniques of production, it has certain resources in the production, it has certain resources in the form of land, water and other natural form of land, water and other natural resources.IT has a certain number of resources.IT has a certain number of inputs. The society has really to decide inputs. The society has really to decide how this resources can be utilised to how this resources can be utilised to produce the various possible commodities. produce the various possible commodities. In other words, it has to discover its In other words, it has to discover its production possibility curve.production possibility curve.

The production possibility curve shows the maximum The production possibility curve shows the maximum output of any one commodity that the economy can output of any one commodity that the economy can

produce together with the prescribed quantities of other produce together with the prescribed quantities of other commodities produced and resources utilised.In short commodities produced and resources utilised.In short

PPT curve tells us what assortment of goods and PPT curve tells us what assortment of goods and services the economy can produce with the resources services the economy can produce with the resources and techniques at its disposal. The assortment on the and techniques at its disposal. The assortment on the

curve is regarded as technologically efficient and below curve is regarded as technologically efficient and below it as inefficient. For the simple reason that the it as inefficient. For the simple reason that the

economic is capable of producing a bigger assortment economic is capable of producing a bigger assortment at least in respect of one commodity without at least in respect of one commodity without

decreasing any other. Any assortment which is beyond decreasing any other. Any assortment which is beyond the frontier is really beyond the economy power and is the frontier is really beyond the economy power and is

unattainable. The PPT curve depicts the society’s unattainable. The PPT curve depicts the society’s menu of choices.menu of choices.

We shall illustrate the concept of PPT curve by means of table We shall illustrate the concept of PPT curve by means of table and a daigram. Let us take two commodities X and Y that a and a daigram. Let us take two commodities X and Y that a

firm can produce. If it decides to devote more of its resouces to firm can produce. If it decides to devote more of its resouces to production X it must sacrifice to that extent production of production X it must sacrifice to that extent production of

Y.Take the following table-Y.Take the following table-

Production Production

possibilitiespossibilities XX

(Thousands)(Thousands) YY

(thousands)(thousands)

AA

BB

CC

DD

EE

FF

00

11

22

33

44

55

1515

1414

1212

99

55

00

Let all the productive resources available devoted Let all the productive resources available devoted to the production of Y with the result that 15,000 Y to the production of Y with the result that 15,000 Y

but no X in between these two extreme limits but no X in between these two extreme limits there are numerous combinations of X and Y that there are numerous combinations of X and Y that can be produced .The PPT curve can be depicted can be produced .The PPT curve can be depicted by means of diagram given below.In this diagram A by means of diagram given below.In this diagram A

represents the one extreme limit at which all y’s represents the one extreme limit at which all y’s are produced now if we want to produce some X are produced now if we want to produce some X

some Y will have to be sacrifice for instance in some Y will have to be sacrifice for instance in order to produce 1000 X we shall have to be order to produce 1000 X we shall have to be

content with 14,000 Y instead of 15,000.We have content with 14,000 Y instead of 15,000.We have transformed 1000 Y into 1000 X and so on down transformed 1000 Y into 1000 X and so on down

the table.So, PPT curve is also called as the table.So, PPT curve is also called as Production transformation curve.Production transformation curve.

Pro

duct

Y (

Th

ousa

nds

)

In the diagram, the curve marks the production In the diagram, the curve marks the production possibility frontier and all points on the curve possibility frontier and all points on the curve represent production possibility, the points represent production possibility, the points

inside the curve are attainable combinations inside the curve are attainable combinations and those outside such as s, t are unattainable and those outside such as s, t are unattainable

combinations. Any point inside the curve combinations. Any point inside the curve represents an under utilisation of resources or represents an under utilisation of resources or under-employment. A fuller utilisation will shift under-employment. A fuller utilisation will shift

the curves outwards. Increase in the resources the curves outwards. Increase in the resources at the disposal of the firm will take it to higher at the disposal of the firm will take it to higher

production possibility curveproduction possibility curve..

MARGINAL RATE OF TRANSFORMATIONMARGINAL RATE OF TRANSFORMATION

We have seen above that in order to produce more We have seen above that in order to produce more X we must sacrifice some Y,that is Y can be X we must sacrifice some Y,that is Y can be transformed into X,the rate at which one products transformed into X,the rate at which one products is transformed into another is called as marginal is transformed into another is called as marginal rate of transformation for instance marginal rate rate of transformation for instance marginal rate of transformation between good X and good Y is of transformation between good X and good Y is the amount of Y which has to be sacrificed for the the amount of Y which has to be sacrificed for the production of X .This makes PPC concave in the production of X .This makes PPC concave in the origin.The MRT at any point on production origin.The MRT at any point on production possibility curve is given by slope of the curve at possibility curve is given by slope of the curve at that point.that point.

ECONOMIC REGION ECONOMIC REGION PRODUCTION (RIDGE LINES)PRODUCTION (RIDGE LINES)

Generally production functions generate Generally production functions generate isoquants which are convex and negatively isoquants which are convex and negatively sloped, do not intersect each other and sloped, do not intersect each other and higher the isoquants greater the level higher the isoquants greater the level output. There are some production output. There are some production functions which yield isoquants having all functions which yield isoquants having all the properties except they are not the properties except they are not negatively sloped segments. In other negatively sloped segments. In other words they are positively sloped segments words they are positively sloped segments

LABOUR

CA

PIT

AL

Let us consider isoquant P3. AB segment Let us consider isoquant P3. AB segment of this isoquant is positively sloped. of this isoquant is positively sloped. Similarly other isoquants have the slope. Similarly other isoquants have the slope. Beyond points A and B this isoquant is Beyond points A and B this isoquant is positively sloped. The points where they positively sloped. The points where they bent back upon themselves implying that bent back upon themselves implying that they become positively sloped. The lines they become positively sloped. The lines OK and OL joining these points are called OK and OL joining these points are called ridge lines. They form the boundaries for ridge lines. They form the boundaries for the economic region of production.the economic region of production.

Suppose the output represented by isoquant P3 is to be Suppose the output represented by isoquant P3 is to be produced. For producing this quantity a minimum of OK2 produced. For producing this quantity a minimum of OK2 amount of capital is required because any smaller amount amount of capital is required because any smaller amount will not allow the producer to attain the P3 level of output. will not allow the producer to attain the P3 level of output. With OK2 amount OL2 amount of labour must be With OK2 amount OL2 amount of labour must be employed.In case the producer uses an amount of labour employed.In case the producer uses an amount of labour less than OL2 together with OK2 amount of capital his less than OL2 together with OK2 amount of capital his output level would be lower than the one represented by output level would be lower than the one represented by isoquant P3.This is quite normal because smaller inputs isoquant P3.This is quite normal because smaller inputs would lead to smaller output.But combining labour input in would lead to smaller output.But combining labour input in an amount larger than OL2 with OK2 amount of capital an amount larger than OL2 with OK2 amount of capital would also result in output smaller than represented by would also result in output smaller than represented by isoquant P3.In oder to maintain P3 level output with a larger isoquant P3.In oder to maintain P3 level output with a larger amount has to be used. This is something no rational amount has to be used. This is something no rational producer would attempt to do because it involves producer would attempt to do because it involves uneconomic use of resources.uneconomic use of resources.

Point B on isoquant P3 represents the Point B on isoquant P3 represents the intensive margin of labour because an intensive margin of labour because an increase in the labour input beyond OL2 increase in the labour input beyond OL2 with fixed amount of capital input OK2 with fixed amount of capital input OK2 results in a fall of in the output level. AT results in a fall of in the output level. AT this point marginal product of labour is this point marginal product of labour is zero and thus the MRTS of labour for zero and thus the MRTS of labour for capital is zero. This implies that at point B capital is zero. This implies that at point B labour has been substituted for capital to labour has been substituted for capital to the maximum extent.the maximum extent.

Similarly for producing P3 level of output a minimum of OL1 Similarly for producing P3 level of output a minimum of OL1 amount labour input in required. A smaller amount of labour amount labour input in required. A smaller amount of labour input will not the producer to attain P3 level of output. With input will not the producer to attain P3 level of output. With OL amount OK1 amount of capital must be used and any OL amount OK1 amount of capital must be used and any additions to capital input beyond OK1 would result in additions to capital input beyond OK1 would result in smaller output. Therefore the marginal product of capital is smaller output. Therefore the marginal product of capital is zero at point A. This point represents intensive margin of zero at point A. This point represents intensive margin of capital because increase in the amount of capital input capital because increase in the amount of capital input beyond OK1 with a fixed labour input of OL1will reduce beyond OK1 with a fixed labour input of OL1will reduce rather than augment output. At point A on P3 capital has rather than augment output. At point A on P3 capital has been substituted for labour to the maximum extent the been substituted for labour to the maximum extent the MRPS of capital for labour is zero which means MRPS of MRPS of capital for labour is zero which means MRPS of labour for capital infinitelabour for capital infinite

The line OK connects the points of zero The line OK connects the points of zero marginal product of capital. We have marginal product of capital. We have designated it as upper ridge line. Similarly designated it as upper ridge line. Similarly the line OL designated as lower ridge line the line OL designated as lower ridge line joins the points of zero marginal product of joins the points of zero marginal product of labour. The combinations of labour and labour. The combinations of labour and capital inputs comprising the area capital inputs comprising the area between ridge lines OL and OK constitute between ridge lines OL and OK constitute the generalized stage2 of production for the generalized stage2 of production for both the resources. These combinations both the resources. These combinations that are relevant for production decisions.that are relevant for production decisions.

Economies of scaleEconomies of scale Large scale production is economical in the sense that the Large scale production is economical in the sense that the

cost of production is low. The low cost leads to economies cost of production is low. The low cost leads to economies of scale.of scale.

The economies of scale can be divided into two broad The economies of scale can be divided into two broad categories as:- a) Internal economies b)External economies.categories as:- a) Internal economies b)External economies.

Internal economies are those economies which occur when Internal economies are those economies which occur when firms size expand. They emerge within the firm itself as its firms size expand. They emerge within the firm itself as its scale of production increases. Internal economies are the scale of production increases. Internal economies are the function of the size of firm.function of the size of firm.

External economies are those economies which are shared External economies are those economies which are shared by all firms in an industry or group when their size expands. by all firms in an industry or group when their size expands. They are available to all firms irrespective of their size and They are available to all firms irrespective of their size and scale of production. These economies are the function of scale of production. These economies are the function of the size of the industry or group of industries as whole.the size of the industry or group of industries as whole.

Forms of internal economiesForms of internal economies Labour economies.Labour economies. Technical economiesTechnical economies a)Economies of superior techniquea)Economies of superior technique b)Economies of increased dimension.b)Economies of increased dimension. c)Economies of linked process.c)Economies of linked process. Managerial economies.Managerial economies. Marketing economies.Marketing economies. Financial economiesFinancial economies Risk minimizing economiesRisk minimizing economies a)By diversification of output.a)By diversification of output. b)By diversification market.b)By diversification market. c)By diversification of sources of supply as well as c)By diversification of sources of supply as well as

process of manufacturing.process of manufacturing.

Forms of external economiesForms of external economies

Economies of localization.Economies of localization. Economies of information or Economies of information or

technical and market intelligence.technical and market intelligence. Economies of vertical disintegration.Economies of vertical disintegration. Economies of byproducts.Economies of byproducts.

Diseconomies of scaleDiseconomies of scale

Difficulties of management.Difficulties of management. Difficulties of coordination.Difficulties of coordination. Difficulties in decision making.Difficulties in decision making. Increased risks.Increased risks. Labour diseconomies.Labour diseconomies. Scarcity of factor inputs.Scarcity of factor inputs. Financial difficulties.Financial difficulties. Marketing difficultiesMarketing difficulties

Economies of scopeEconomies of scope

The concept of economies of scope is often The concept of economies of scope is often somewhat used differently than the concept of somewhat used differently than the concept of economies of scope.economies of scope.

It refers to reduction in unit cost realised when It refers to reduction in unit cost realised when firm produces two or more products jointly rather firm produces two or more products jointly rather than seperately.than seperately.

A multi product firm often experiences economies A multi product firm often experiences economies of scope. These economies exist when a firm of scope. These economies exist when a firm produces two products together undser the same produces two products together undser the same production facilities as against producing them production facilities as against producing them under separate facilities. Thus :-under separate facilities. Thus :-

TC(QTC(QXX ,Q ,QYY )<TC(Q )<TC(QX,X, 0)+TC(0 Q 0)+TC(0 QYY ) )

ILLUSTRATIONILLUSTRATION A firms total cost function isA firms total cost function is TC=200-QTC=200-QX X QQY Y +Q +QX X

2 2 QQYY22

Where QWhere QXX and and Q QY Y represent the number of units of product x represent the number of units of product x and y.and y.

Do economies of scope exist when the firm produces 2 units of Do economies of scope exist when the firm produces 2 units of x and 4 units of y?x and 4 units of y?

TC(QTC(QXX ,Q ,QYY )<TC(Q )<TC(QX,X, 0)+TC(0 Q 0)+TC(0 QYY ) ) TC(QTC(QXX ,Q ,QYY ) 200-(2)(4)+(2) ) 200-(2)(4)+(2)22 +(4) +(4)22

=200-8+4+16=212=200-8+4+16=212 TC(QTC(QXX ,0)=200 Q ,0)=200 Qxx (0) (0) + Q + QX X

2 2 +(0) +(0)2 2

=200 + Q=200 + QX X 2 2 =200+(2) =200+(2)2 2 =204=204

TC(0, QTC(0, QY Y )=200-(0) )=200-(0) QQY Y +(0) +(0)22 +(Q+(QY Y ) )22

=200+ Q=200+ QY Y 22 =200 +(4) =200 +(4)22=216=216

Since (212)<(204+216) it follows that economies of scope exist.Since (212)<(204+216) it follows that economies of scope exist.

Degree of economies of scaleDegree of economies of scale

The degree of economies of scope can be measured in The degree of economies of scope can be measured in terms of the difference in the cost of production jointly and terms of the difference in the cost of production jointly and separately. The formula is used to measure the degree of separately. The formula is used to measure the degree of economies of scope.economies of scope.

DES=TC(An)+TC (Bn)-TC (An+Bn)/TC(An+Bn)DES=TC(An)+TC (Bn)-TC (An+Bn)/TC(An+Bn) Where,Where, DES=degree of economies of scope.DES=degree of economies of scope. TC(An)=Total cost of producing An units of product A TC(An)=Total cost of producing An units of product A

separately.separately. TC(Bn)=Total cost of producing Bn Units of products B TC(Bn)=Total cost of producing Bn Units of products B

separately.separately. TC(An+Bn)=Total cost of producing products A and B jointly, TC(An+Bn)=Total cost of producing products A and B jointly,

that is producing An units of product A and Bn units of that is producing An units of product A and Bn units of product B together.product B together.

Learning curve Learning curve Experience is the best teacher in business. Over time when Experience is the best teacher in business. Over time when

the firm accumulates its business experience it may tend to the firm accumulates its business experience it may tend to improve its production organization methods with improve its production organization methods with improved knowledge and experience of management and improved knowledge and experience of management and labour used in production process.labour used in production process.

The firm’s learning experience would pay in terms of cost of The firm’s learning experience would pay in terms of cost of production. In long run these tends to the downward shifts production. In long run these tends to the downward shifts in the average cost curve of the firm on account of learning in the average cost curve of the firm on account of learning experience effect that improves productive efficiency of the experience effect that improves productive efficiency of the firm in its operations over a time.firm in its operations over a time.

Learning effect is different from scale economy effect. It is Learning effect is different from scale economy effect. It is the difference between actual average cost and estimatede the difference between actual average cost and estimatede average cost. It implies saving in cost .average cost. It implies saving in cost .

Economies of scale are measured through a give LAC as a Economies of scale are measured through a give LAC as a change in the level of output per time period. The learning change in the level of output per time period. The learning effect rate can be measured by using a formula:-effect rate can be measured by using a formula:-

LER=[1-ACtLER=[1-ACt11 /ACt /ACt00 ]*100 ]*100 Where ,Where , LER=learning effect rate.LER=learning effect rate. ACtACt00 =average cost in initial period (t =average cost in initial period (t00) increment.) increment. ACtACt1 1 =average cost in next period(t=average cost in next period(t11) increment.) increment. Incidentally the ratio ACtIncidentally the ratio ACt11 / ACt / ACt0 0 is referred to as experience is referred to as experience

factor.factor.

X efficiencyX efficiency Cost economy is the major goal of a business firm. Cost economy is the major goal of a business firm.

Efficiency in production implies cost economy. An efficient Efficiency in production implies cost economy. An efficient firm will tend to experience lower cost function. When the firm will tend to experience lower cost function. When the efficiency improves cost function of the firm tends to shift efficiency improves cost function of the firm tends to shift downwards.downwards.

In practice a major way of cost reduction is seen through In practice a major way of cost reduction is seen through minimization of the wastage of resources. More wastage minimization of the wastage of resources. More wastage implies higher cost. Low wastage means low cost.implies higher cost. Low wastage means low cost.

X efficiency is a function of management to reduce and X efficiency is a function of management to reduce and minimize the waste of resources in operations. New minimize the waste of resources in operations. New approaches such as Six Sigma methodology are essentially approaches such as Six Sigma methodology are essentially meant towards attainment of X efficiency (waste meant towards attainment of X efficiency (waste minimization as well as zero defect level) of business firm.minimization as well as zero defect level) of business firm.