unit -3 production cost analysis

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Unit 3

3.1Production Cost Analysis

3.1.1 Introduction

A business firm is an economic unit. It is also called as a production unit. Production

is one of the most important activities of a firm in the circle of economic activity. The main

objective of production is to satisfy the demand for different kinds of goods and services of the

community.

3.1.2 Meaning of Production

The concept of production can be represented in the following manner.

The term Production means transformation of physical Inputs into physical Outputs.

The term Inputs refers to all those things or items which are re uired by the firm to

produce a particular product. Four factors of production are land, labor, capital and

organization.

In addition to four factors of production! inputs also include other items like raw

materials of all kinds! power! fuel! water! technology! time and services like transport and

communications! warehousing! marketing! banking! shipping and Insurance etc. It also includes

the ability! talents! capacities! inputs.

Production always results in either creation of new utilities or addition of values. It isan activity that increases consumer satiability of goods and services. Production is undertaken by

producers and basically it depends on cost of production. Production analysis is always made in

physical terms and it shows the relationship between physical inputs and physical outputs.

It is to be noted that higher levels of production is an inde" of progress and growth of an

organi#ation and that of a society. It leads to higher income! employment and economic1


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prosperity. Production of different types of goods and services in different nations indicates the

nature of economic inter dependence between different nations.

The primary and the ultimate aim of the economic activity is the satisfaction of

human wants. In order to satisfy these wants individuals have to put in efforts to produce goods

$ services. %ithout production there cannot be satisfaction of wants.

&ommonly understood! production refers to creation of something tangible which

can be used to satisfy human want.

'owever! matter already e"ists. %e cannot create a matter. %e can only add utilities to

the e"isting matter by either changing its form! place or keeping it over time $ create values. (or

e"ample) %e can transform a log of wood into a piece of furniture! thereby adding utility. This

process of addition of utilities to the e"isting matter by changing its form! place and keeping itover time is referred to as Production in *conomics. %e can therefore add form utility! time

utility! place utility or personnel utility.

Addition of all such utilities to the e"isting matter is referred to as Production in

*conomics. 'owever technologically production is referred to as the process of transforming

inputs into output. In order to undertake production we re uire certain factors of production such

as land! labour! capital $ organi#ation. These factors are the inputs $ the product that emerges at

the end of the process of production is referred to as the output.

3.1.3 Agents of production

The agents of production are broadly classified into four categories! vi#.

+and

+abour

&apital and

,rganisation.

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-i +and in economics has a much wider connotation than being understood merely as a

portion of the surface of the earth. In economics! land refers to all the natural resources

found on! above and under the surface of the earth and which essentially free gifts of

/ature are.

-ii +abour essentially refers to the human factor in the process of production. +abour in

economics may be defined as human efforts! mental or manual! undertaken in order to

add utilities and create values.

-iii &apital is a man0made factor of production. %hen labour works on land! it produces two

types of goods! consumers1 goods which directly satisfy human wants and capital goods

which satisfy human wants only indirectly. &apital goods are those goods which are used

to produce other goods. Thus &apital is often defined as the produced means for further production.

-iv ,rgani#ation refers to that factor of production which coordinates the various other

factors -+and! +abour! and &apital in a manner so as to minimi#e the cost of production

and ma"imi#e the output.

Production, as such has two dimensions

-i Technical or Physical and

-ii -ii (inancial.

In Technical sense production is concerned with conversion of inputs into output.

'owever it should be noted here that production does not necessarily imply merely a physical

conversion of inputs into a physically new unit of output.2 but processes like transportation and

storage should also be incorporated in the definition of production for they too are involved inaddition of utilities to goods. An input refers to any good or service which enters the process of

production and an output is the resulting good which emerges as the conse uence of production

process.

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There is also the financial dimension to the process of production. In fact!

production involves cost. &ertain amount of e"penditure is to be incurred to initiate and continue

production.

3.2 Production function

The entire theory of production centre round the concept of production function. A

production (unction e"presses the technological or engineering relationship between physical

uantity of inputs employed and physical uantity of outputs obtained by a firm. It specifies a

flow of output resulting from a flow of inputs during a specified period of time. It may be in the

form of a table! a graph or an e uation specifying ma"imum output rate from a given amount of

inputs used. 3ince it relates inputs to outputs! it is also called as Input output relation. The

production is purely physical in nature and is determined by the uantum of technology!

availability of e uipments! labor! and raw materials! and so on employed by a firm.

A production function can be represented in the form of a mathematical model or

e uation as 4 5 f -+! /! 67.etc where 4 stands for uantity of output per unit of time and + /

6 etc are the various factor inputs like land! capital labor etc which are used in the production of

output. The rate of output 4 is thus! a function of the factor inputs + / 6 etc! employed by the

firm per unit of time.

In microeconomics and macroeconomics! a production function is a function that

specifies the output of a firm! an industry! or an entire economy for all combinations of inputs.

. This function is an assumed technological relationship! based on the current state of

engineering knowledge2 it does not represent the result of economic choices! but rather is an

e"ternally given entity that influences economic decision0making. Almost all economic theories

presuppose a production function! either on the firm level or the aggregate level. In this sense!

the production function is one of the key concepts of mainstream neoclassical theories. 3ome

non0mainstream economists! however! reject the very concept of an aggregate production

function.

Figure - A4


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Figure -B

The technological relationship between inputs and output of a firm is generally

referred to as the production function. The production function shows the functional relationship

between the physical inputs and the physical output of a firm in the process of production.

The production function is the Technical relationship telling the ma"imum amount of outputcapable of being produced by each and every set of specified inputs. It is defined for a given set

of technical knowledge. 8 3amuelson.

According to 3tigler! the production function is the name given to the relationship between the

rates of input of productive services and the rate of output of product. It is the economist1s

summary of technical knowledge.

In fact the production function shows the ma"imum uantity of output. 4! that can

be produced as a function of the uantities of inputs 9:! 9;! 9


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T -read T bar 2 stands for a given 3tate of Technology2 Technology held constant.

Production function! thus e"presses the technological functional relationship

between inputs and output. It shows that output is the function of several inputs. =esides! the

Production function must be considered with reference to a particular period of time and for agiven state of technology.

It may be remembered that the Production function shows only the physical

relationship between inputs and the output. It is basically an engineering concept2 whereas

selecting an optimal input combination is an economic decision which re uires additional

information with respect to prices of the factor inputs and the market demand for the output.

3.2.1 !at is Production Function"

Production of goods re uires resources or inputs. These inputs are called factors of

production named as land! labor! capital and organi#ation. A rational producer is always

interested that he should get the ma"imum output from the set of resources or inputs available to

him. 'e would like to combine these inputs in a technical efficient manner so that he obtains

ma"imum desired output of goods. The relationship between the inputs and the resulting output

is described as production function. A production function shows the relationship between the

amounts of factors used and the amount of output generated per period of time.

It can be e"pressed in algebraic form as under)

9 5 f -a:! a; !........! an

This e uation tells us the uantity of the product 9 which can be produced by the

given uantities of inputs -lands labor! capital that are used in the process of production. 'ere it

may be noted that production function shows only the ma"imum amount of output which can be

produced from given inputs. It is because production function includes only efficient production process.

The analysis of production function is generally carried with reference to time

period which is called short period and long period. In the short run! production function is

e"plained with one variable factor and other factors of productions are held constant. %e have

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called this production function as the +aw of >ariable Proportions or the +aw of ?iminishing

returns.

In the long run! production function is e"plained by assuming all the factors of

production as variable. There are no fi"ed inputs in the long run. 'ere the production function iscalled the +aw of @eturns according to the scale of production. As it is difficult to handle more

than two variables in graph! we therefore! e"plain the +aw of @eturns according to scale of

production by assuming only two inputs i.e.! capital and labor and study how output responds to

their use. %e first of all e"plain the concept of iso uants and their properties.

3.2.2 Factor inputs are of t#o types.

1. Fi$ed Inputs. (i"ed inputs are those factors the uantity of which remains constant

irrespective of the level of output produced by a firm.

(or e"ample! land! buildings! machines! tools! e uipments! superior types of labor!

top management etc.

2. %aria&le inputs. >ariable inputs are those factors the uantity of which varies with variations

in the levels of output produced by a firm

(or e"ample! raw materials! power! fuel! water! transport and communication etc.The distinction between the two will hold good only in the short run. In the long run! all factor

inputs will become variable in nature.

Short run is a period of time in hich only the !ariable factors can be !aried

hile fi"ed factors li#e plants, machineries, top management etc ould remain constant. Time

available at the disposal of a producer to make changes in the uantum of factor inputs is very

much limited in the short run.

$ong run is a period of time here in the producer ill ha!e ade%uate time to

ma#e any sort of changes in the factor combinations. It is necessary to note that production

function is assumed to be a continuous function! i.e. it is assumed that a change in any of the

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variable factors produces corresponding changes in the out put. enerally speaking! there are

two types of production functions.

They are as follows2

a. '!ort Period Analysis of Production

The short run is a period of time in which only one input -say labor is allowed to

vary while other inputs land and capital are held fi"ed. In the short run! therefore! production can

be increased with one variable factor and other factors remaining constant. In the short run! the

law of variable proportion governs the production behavior of a firm. The law of variable

proportion shows the direction and rate of change in the output of firm when the amount of only

one factor of production is varied while other factor of production are held constant. The law of

variable proportion passes mainly through two phases!

:. Increasing @eturns and

;. ?iminishing @eturns.

In this case! the producer will keep all fi"ed factors as constant and change only a

few variable factor inputs. In the short run! we come across two kinds of production functions.

:. 4uantities of all inputs both fi"ed and variable will be kept constant and only one variable

input will be varied.

(or e"ample! +aw of >ariable Proportions.

;. 4uantities of all factor inputs are kept constant and only two variable factor inputs are varied.

(or e"ample! Iso4uants and Iso&ost curves.

&. (ec!nical )fficient Co*&ination

Production function establishes a physical relationship between output and inputs.

It describes what is technical feasible when the firm uses each combination of input. The firm

can obtain a given level of output by using more labor and less capital or more capital and less

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labor. Production function describes the ma"imum output feasible for a given set of inputs in

technical efficient manner.

3.2.3 Production Function ta+es ,uantities of Inputs

It is imperative to note that production function does not take unto account the

prices of input or of the output. It simply takes into account the uantities of inputs which are

employed to produce certain uantities of output.

3.2. ong /un Production #it! %aria&le Inputs

The long run is the lengthy period of time during with all inputs can be varied. There

are no fi"ed output in the long run. All factors of production are variable inputs.

%e now analy#e production function by allowing two factors say labor and capital to

very while all others are held constant. %ith both factors are variable! a firm can produce a given

level of output by using more labor and less capital or a greater amount of capital and less labor

or moderate amounts of both. A firm continues to substitute one input for another while

continuing to produce the same level of output.

If two inputs say labor and capital are allowed to vary! the resulting production

function can be illustrated in the figure :;-a .

In this figure each curve -called an iso uant represents a different level of output.

The curves which lie higher and to the right represent greater output levels than curves which are

lower and to the left.

(or e"ample! point ? represents a higher output level of ;BC units than point A or =

which shows output level of :BC units.

The curve iso uant which represents :BC units of output illustrate that the same levelof output -:BC units can be produced with different combinations of labor and capital.

&ombination of labor and capital represented by A! can employ ,+: uantity of labor and ,&:

units of capital to produce :BC units of output. The combination of labor and capital represented

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by point = will use only ,+; units of labor and ,&: of capital to produce the same level of

output.

Thus! if a country has surplus labor and less capital! it may use the combination of

labor and capital represented by point A. In case the country has abundant capital and less labor!it might produce at point =. The iso uants through points A and = shows all the different

combinations of labor and capita that can be used to produce :BC units of output.

In this case! the producer will vary the uantities of all factor inputs! both fi"ed as

well as variable in the same proportion.

(or *"ample! The laws of returns to scale.

*ach firm has its own production function which is determined by the state of

technology! managerial ability! organi#ational skills etc of a firm. If there are any improvements

in them! the old production function is disturbed and a new one takes its place. It may be in the

following manner)

:. The uantity of inputs may be reduced while the uantity of output may remain same.

;. The uantity of output may increase while the uantity of inputs may remain same.


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:. It can be used to calculate or work out the least cost input combination for a given output or

the ma"imum output input combination for a given cost.

;. It is useful in working out an optimum! and economic combination of inputs for getting a

certain level of output. The utility of employing a unit of variable factor input in the production

process can be better judged with the help of production function. Additional employment of a

variable factor input is desirable only when the marginal revenue productivity of that variable

factor input is greater than or e ual to cost of employing it in an organi#ation.


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predicted by the economist. The level of production depends on technical conditions. If there is

improvement in the techni ue of production! increased output can be obtained even with the

same -fi"ed uantity of factors. 'owever! at a given point of time! there is only one ma"imum

level of output that can be obtained with a given combination of factors of production. This

technical law which e"presses the relationship between factor inputs and output is termed as

production function.

Fi$ed Inputs

A fi"ed input is defined as one whose uantity cannot be changed instantaneously in

response to changes in market conditions re uiring an immediate change in output.

e.g.! =uildings! major capital e uipments and managerial personnel. >ariable Inputs

A variable input is one whose uantity can be changed readily when market condition

suggests that an immediate change in output is beneficial to the producer.

e.g. raw materials and labour services. 3hort @un

The short run is that period of time in which uantity of one or more inputs remains fi"ed

irrespective of the volume of output.

Therefore! if output is to be increased or decreased in the short run! change e"clusively in

the uantity of variable inputs is to be made. +ong @un

+ong run refers to that period of time in which all inputs are variable.

Thus! the producer does not feel constrained in any way while changing the output.

In the long run it is possible for the producer to make output changes in the most

advantageous way. Production process or method of production is a combination offactor inputs for producing one unit of output

3.3.1 Production Function #it! ne %aria&le Input Case

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a. ( ) A F %A/IAB ) P/ P /(I '

This law is one of the most fundamental laws of production. It gives us one of the

key insights to the working out of the most ideal combination of factor inputs. All factor inputs

are not available in plenty. 'ence! in order to e"pand the output! scarce factors must be kept

constant and variable factors are to increased in greater uantities. Additional units of a variable

factor on the fi"ed factors will certainly mean a variation in output.

The law of variable proportions or the law of non0proportional output will e"plain

how variation in one factor input give place for variations in outputs.

The law can be stated as the following.

&s the %uantity of different units of only one factor input is increased to a gi!en %uantity of

fi"ed factors, beyond a particular point, the marginal, a!erage and total output e!entually

decline

The law of variable proportions is the new name for the famous 4 a# of

5i*inis!ing /eturns6 of classical economists. This law is stated by various economists in the

following manner

According to Prof. Benham, &s the proportion of one factor in a combination of factors is

increased, after a point, first the marginal and then the a!erage product of that factor ill

diminish .

The same idea has been e"pressed by Prof.Darshall in the following words. An increase in the

uantity of a variable factor added to fi"ed factors! at the end results in a less than proportionate

increase in the amount of product! given technical conditions.

&. A''UMP(I ' F ( ) A

,nly one variable factor unit is to be varied while all other factors should be kept

constant.

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?ifferent units of a variable factor are homogeneous.

Techni ues of production remain constant.

The law will hold good only for a short and a given period.

There are possibilities for varying the proportion of factor inputs.

Illustration

A hypothetical production schedule is worked out to e"plain the operation of the law.

(i"ed factors 5 : Acre of land F @s BCCC0CC capital. >ariable factor 5 labor.

Units of Variableinputs (Labor)

TP in units AP in units MP in units

C 0 C C

: :C :C :C

; ;G :; :G

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variable factors employed.

Marginal Product or utput ) -DP It is the output derived from the employment of an

additional unit of variable factor unit

(rends in output

(rom the table! one can observe the following tendencies in the TP! AP! $ DP.

:. Total output goes on increasing as long as DP is positive. It is the highest when DP is #ero

and TP declines when DP becomes negative.

;. DP increases in the beginning! reaches the highest point and diminishes at the end.


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:. The proportion of fi"ed factors is greater than the uantity of variable factors. %hen the

producer increases the uantity of variable factor! intensive and effective utili#ation of fi"ed

factors become possible leading to higher output.

;. %hen the producer increases the uantity of variable factor! output increases due to the

complete utili#ation. of the Indivisible (actors


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(!e III 'tage (!e 'tage f egati7e /eturns.

In this case! as the uantity of variable input is increased to a given uantity of

fi"ed factors! output becomes negative. ?uring this stage! TP starts diminishing! AP continues to

diminish and DP becomes negative. The negative returns are the result of e"cessive uantity of

variable factors to a constant uantity of fi"ed factors. 'ence! output declines. The proverb Too

many cooks spoil the broth and Too much is too bad aptly applies to this stage. enerally!

the III stage is a theoretical possibility because no producer would like to come to this stage.

The producer being rational will not select either the stage I -because there is

opportunity for him

to increase output by employing more units of variable factor or the III stage -because the DP is

negative . The stage I $ III is described as /on economic @egion or Mneconomic @egion.'ence! the producer will select the II stage -which is described as the most

economic region where he can ma"imi#e the output. The II stage represents the range of rational

production decision.

It is clear that in the abo!e e"ample, the most ideal or optimum combination of

factor units ' ( &cre of land) *s. + - capital and laborers.

All the < stages together constitute the law of variable proportions. 3ince the second

stage is the most important! in practice we normally refer this law as the law of ?iminishing

@eturns.

3.3.2 Practical application of t!e la#

:. It helps a producer to work out the most ideal combination of factor inputs or the least cost

combination of factor inputs.

;. It is useful to a businessman in the short run production planning at the micro0level.


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:. The marginal productivity of factors of production.

;. The marginal rate of technical substitution.


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In the initial stages of cultivation of a given piece of land! perhaps due to under0

cultivation of land! when additional units of capital and labour are invested! additional output

may be more than proportionate. =ut after a certain e"tent when the land is cultivated with some

more investment! the additional output will be less than proportionate under all normal

circumstances! unless some improvements take place in the methods of techni ues of cultivation.

. The law is applicable to all fields of production such as industry! mining! house

construction! besides agriculture.

Assu*ptions of t!e a# of 5i*inis!ing Marginal /eturns

The law of diminishing marginal returns holds good subject the following two

conditions)0

N:. 3ame technology is used throughout the process of production. %hatever change takes place

in the proportion of factor inputs is within the scope of available methods and techni ues.

N;. Mnits of different factor inputs are perfectly homogeneous2 every unit is of e ual efficiency

and therefore! are interchangeable with any other factor input in the production function.

a. a# of %aria&le Proportions

NProf. =enham states the law as follows)

As the proportion of one factor in a combination of factors is increased after a point! the average

and marginal production of that factor will diminish.

. . 3tigler) NAs e ual increments of one input are added! the inputs of other productive

services being held constant! beyond a certain point the resulting increments of product will

decrease! i.e. the marginal product will diminish.

NThe law is summarised thus)NIn the short run! as the amount of variable factors

increases! other things remaining e ual! output -or the returns to the factors varied will increase

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more than proportionately to the amount of variable inputs in the beginning! then it may increase

in the same proportion and ultimately it will increase less proportionately.

&. a# of %aria&le Proportions

NThe conditions underlying the law are )

,nly one factor is varied2 all other factors remain constant.

The scale of output is unchanged and production capacity remains constant.

Techni ue of production is unchanged.

All units of factor input varied! are homogeneous 8 all units have identical efficiencies

and characteristics.

All factors of production cannot be substituted for one another. Deasurements of the

Product

c. (otal Product

Total number of units produced per unit of time by all factor inputs in referred to

as total product. In the short run! since Total Product -output -TP increases with an increase in

the 4uantity of >ariable (actor -4>( ! TP 5 f-4>( . NAverage Product) Average Product refers

to the total product per unit of the given variable factor. AP 5 TPE4>( NDarginal Product)

,wing to the addition of a unit to a variable factor! all other factors being held constant! the

additional realised in the total product is technically called marginal product. QDPn 5 TPn 8

TPn0: Q

:.3tage I 8 The law of diminishing returns becomes evident in the marginal product line. Initiallythe marginal product of the variable input -labour rises. The total product rises at an increasing

rate -5marginal product . Average product also rises. This is the stage of increasing returns.

;.3tage II 8 @eaching a certain point! the marginal product begins to diminish. Thus! the rate of

increase in the total output slows down. This is the stage of diminishing returns. %hen the

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The long0run production function may be summari#ed as

4 5 f -l! k

%here both labour and capital are variable inputs. 3ince in short0run! not all

inputs can be varied simultaneously! the proportions in which inputs are combined go on

varying. There fore the analysis of input0output relation depicted by the short0run production

function is called the @eturns to >ariable Proportions. It takes shape in the +aws of @eturns.

%hereas the long0run production function gives the input0output relationship when all inputs are

varied. In fact economists are particularly interested in finding out as to what happens to the

output when all inputs are varied proportionately. This analysis of relationship between

proportionate change in inputs and the resulting output gives rise to proportionate change in

inputs and the resulting output gives rise to @eturns to 3cale.

3.3.9 a#s of returns and returns to scale

/eturns to scale: returns to scale! in economics! the uantitative change in output

of a firm or industry resulting from a proportionate increase in all inputs. If the uantity of output

rises by a greater proportionRe.g.! if output increases by ;.B times in response to a doubling of

all inputsRthe production process is said to e"hibit increasing returns to scale. 3uch economies

of scale may occur because greater efficiency is obtained as the firm moves from small0 to large0scale operations. ?ecreasing returns to scale occur if the production process becomes less

efficient as production is e"panded! as when a firm becomes too large to be managed effectively

as a single unit.

In economics! returns to scale and economies of scale are related terms that

describe what happens as the scale of production increases in the long run! when all input levels

including physical capital usage are variable -chosen by the firm . They are different terms and

should not be used interchangeably.

The term returns to scale arises in the conte"t of a firmSs production function. It

refers to changes in output resulting from a proportional change in all inputs -where all inputs

increase by a constant factor . If output increases by that same proportional change then there are

constant returns to scale -&@3 . If output increases by less than that proportional change! there

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are decreasing returns to scale -?@3 . If output increases by more than that proportional change!

there are increasing returns to scale -I@3 . Thus the returns to scale faced by a firm are purely

technologically imposed and are not influenced by economic decisions or by market conditions.

A firmSs production function could e"hibit different types of returns to scale indifferent ranges of output. Typically! there could be increasing returns at relatively low output

levels! decreasing returns at relatively high output levels! and constant returns at one output level

between those ranges.

An economic concept referring to a situation in which economies of scale no

longer function for a firm. @ather than e"periencing continued decreasing costs per increase in

output! firms see an increase in marginal cost when output is increased.

)$a*ple

%hen all inputs increase by a factor of ;! new values for output will be)

Twice the previous output if there are constant returns to scale -&@3

+ess than twice the previous output if there are decreasing returns to scale -?@3

Dore than twice the previous output if there are increasing returns to scale -I@3

Assuming that the factor costs are constant -that is! that the firm is a perfect

competitor in all input markets ! a firm e"periencing constant returns will have constant long0run

average costs! a firm e"periencing decreasing returns will have increasing long0run average

costs! and a firm e"periencing increasing returns will have decreasing long0run average costs.

'owever! this relationship breaks down if the firm is not a perfect competitor in the input

markets.

(or e"ample! if there are increasing returns to scale in some range of output levels!

but the firm is so big in one or more input markets that increasing its purchases of an input drives

up the inputSs per0unit cost! then the firm could have diseconomies of scale in that range of

output levels. &onversely! if the firm is able to get bulk discounts of an input! then it could have

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economies of scale in some range of output levels even if it has decreasing returns in production

in that output range.

et#or+ effect

/etwork e"ternalities resemble economies of scale! but they are not considered

such because they are a function of the number of users of a good or service in an industry! not

of the production efficiency within a business. *conomies of scale e"ternal to the firm -or

industry wide scale economies are only considered e"amples of network e"ternalities if they are

driven by demand side economies.

For*al definitions

(ormally! a production function is defined to have)

constant returns to scale if -for any constant a greater than or e ual to :

increasing returns to scale if -for any constant a greater than :

decreasing returns to scale if -for any constant a greater than :

where 6 and + are factors of production! capital and labor! respectively.

For*al e$a*ple

The &obb0?ouglas functional form has constant returns to scale when the sum of

the e"ponents adds up to one. The function is) where A O C and C b :. Thus =ut if the &obb0

?ouglas production function has its general form

with C c :! then there are increasing returns if b F c O : but decreasing returns if b F c :!

since which is greater than or less than a(-6!+ as bFc is greater or less than one.

3. A ' F /)(U/ '

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The relationship between the inputs and the output in the process of production is

clearly e"plained by the +aws of @eturns or the +aw of >ariable Proportions.This law e"amines

the production function with only one factor variable! keeping the uantities of other factors

constant. The laws of returns comprise of three phases)

-a The +aw of Increasing @eturns.

-b The +aw of &onstant @eturns.

-c The +aw of ?iminishing @eturns.

The +aws of @eturns may be stated as follows)

If in any process of production! the factors of production are so combined that if

the varying uantity of one factor is combined with the fi"ed uantity of other factor -or factors !

then there will be three tendencies about the additional output or marginal returns)

-i (irstly! in the beginning! as more and more units of a variable factor are added to the

units of a fi"ed factor! the additional output or Darginal @eturns will go on

increasing. 'ere we have the +aw of Increasing @eturns operating.

-ii 3econdly! if still more units of variable factor inputs are added to the units of a fi"ed

factor! the additional output or marginal returns will remain constant. The +aw of

&onstant @eturns begins to operate2 and

-iii (inally! if still more units of variable factors are fed into the process of production!

then the additional output or marginal returns begins to decline. Thus! eventually! we

have the operation of the +aw of ?iminishing @eturns. %e can best illustrate thesethree stages of +aw of @eturns with the help of a model. +et us assume that a farmer

has a fi"ed si#e of land! say one

3. .1 )cono*ies of 'cale

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The study of economies of scale is associated with large scale production. Today

there is a general tendency to organi#e production on a large scale basis. Dass production of

standardi#ed goods has become the order of the day. +arge scale production is beneficial and

economical in nature. The ad!antages or benefits that accrue to a firm as a result of increase

in its scale of production are called /0conomies of scale1 . They have close relationship with the

si#e of the firm. They influence the average cost over different ranges of output. They are gain to

a firm. They help in reducing production cost and establishing an optimum si#e of a firm. Thus!

they help a lot and go a long way in the development and growth of a firm.

According to Prof. Darshall these economies are of two types! vi# Internal *conomies and

*"ternal *conomics.

I. Internal )cono*ies or /eal )cono*ies

Internal *conomies are those economies which arise because of the actions of

an individual firm to economi#e its cost. They arise due to increased division of labor or

speciali#ation and complete utili#ation of indivisible factor inputs. Prof. &airncross points out

that internal economies are open to a single factory or a single firm independently of the actions

of other firms. They arise on account of an increase in the scale of output of a firm and cannot be

achieved unless output increases.

The following are some of the important aspects of internal economies.

:. They arise with in or inside a firm.

;. They arise due to improvements in internal factors.


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3. .2 ;inds of Internal )cono*ies

1. (ec!nical )cono*ies

These economies arise on account of technological improvements and its

practical application in the field of business. *conomies of techni ues or technical economies are

further subdivided into five heads.

a. )cono*ies of superior tec!ni


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(or e"ample! cane pulp! molasses! and abases of sugar factory can be used for the

production of paper! varnish distilleries etc.

e. In7entory )cono*ies=

Inventory management is a part of better materials management. A big firm

can save a lot of money by adopting latest inventory management techni ues.

(or e"ample! ust0In0Time or #ero level inventory techni ues. The rationale of

the ust0in0Time techni ue is that instead of having huge stocks worth of lakhs and &rores of

rupees! it can ask the seller of the inputs to supply them just before the commencement of work

in the production department each day.

;. Managerial )cono*ies.

They arise because of better! efficient! and scientific management of a firm. 3uch

economies arise into different ways.

a. 5elegation of details=

The general manager of a firm cannot look after the working of all processes of

production. In order to keep an eye on each production process he has to delegate some of his

powers or functions to trained or speciali#ed personnel and thus relieve himself for coordination!

planning and e"ecuting the plans. This will enable him to bring about improvements in

production process and in bringing down the cost of production.

&. Functional 'peciali>ation=

It is possible to secure economies of large scale production by dividing the work

of management into several separate departments. *ach department is placed under an e"pert and

the rest of the work is left into the hands of specialists. This will ensure better and more efficient

productive management with scientific business administration. This would lead to higher

efficiency and reduction in the cost of production.


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These economies ill arise on account of buying and selling goods on large

scale basis at fa!orable terms. A large firm can buy raw materials and other inputs in bulk at

concessional rates.

As the bargaining capacity of a big firm is much greater than that of small firms!

it can get uantity discounts and rebates. In this way economies may be secured in the purchase

of different inputs.

A firm can reduce its selling costs also. A large firm can have its own sales

agency and channel. The firm can have a separate selling organi#ation! marketing department

manned by e"perts who are well versed in the art of pushing the products in the market. It can

follow an aggressive sales promotion policy to influence the decisions of the consumers

G.Financial )cono*ies= They arise because of the ad!antages secured by a firm in mobilizing huge

financial resources. A large firm on account of its reputation! name and fame can mobili#e huge

funds from money market! capital market! and other private financial institutions at concessional

interest rates. It can borrow from banks at relatively cheaper rates. It is also possible to have

large overdrafts from banks. A large firm can float debentures and issue shares and get

subscribed by the general public.

Another advantage will be that the raw material suppliers! machine suppliers etc.!

are willing to supply material and components at comparatively low rates! because they are

likely to get bulk orders. Thus! a big firm has an edge over small firms in securing sufficient

funds more easily and cheaply.

B. a&or )cono*ies=

These economies ill arise as a result of employing s#illed, trained, %ualified

and highly e"perienced persons by offering higher ages and salaries. As a firm e"pands! it

can employ a large number of highly talented persons and get the benefits of speciali#ation and

division of labor. It can also impart training to e"isting labor force in order to raise skills!

efficiency and productivity of workers.

/ew schemes may be chalked out to speed up the work! conserve the scarce

resources! economi#e the e"penditure and save labor time. It can provide better working

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conditions promotional opportunities! rest rooms! sports rooms etc! and create facilities like

subsidi#ed canteen! crUches for infants! recreations. All these measures will definitely raise the

average productivity of a worker and reduce the cost per unit output.

. (ransport and 'torage )cono*ies=

They arise on account of the pro!ision of better, highly organized and cheap

transport and storage facilities and their complete utilization. A large company can have its

own fleet of vehicles or means of transport which are more economical than hired ones.

3imilarly! a firm can also have its own storage facilities which reduce cost of operations.

K. 7er ead )cono*ies=

These economies ill arise on account of large scale operations. The e"penses onestablishment! administration! bookkeeping! etc! are more or less the same whether production is

carried on small or large scale. 'ence! cost per unit will be low if production is organi#ed on

large scale.

?. )cono*ies of %ertical integration=

& firm can also reap this benefit hen it succeeds in integrating a number of

stages of production. It secures the advantages that the flow of goods through various stages in

production processes is more readily controlled. =ecause of vertical integration! most of the costs

become controllable costs which help an enterprise to reduce cost of production.

H. /is+ &earing or sur7i7al econo*ies=

These economies ill arise as a result of a!oiding or minimizing se!eral #inds

of ris#s and uncertainties in a business. A manufacturing unit has to face a number of risks in

the business. Mnless these risks are effectively tackled! the survival of the firm may become!

difficult. 'ence many steps are taken by a firm to eliminate or to avoid or to minimi#e various

kinds of risks.

enerally speaking! the risk0bearing capacity of a big firm will be much greater

than that of a small firm. @isk is avoided when few firms amalgamate or join together or when

competition between different firms is either eliminated or reduced to the minimum or e"panding

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the si#e of the firm. A large firm secures risk0spreading advantages in either of the four ways or

through all of them.

5i7ersification of output Instead of producing only one particular variety! a firm has to

produce multiple products if there is loss in one item it can be made good in other items.

5i7ersification of *ar+et ) Instead of selling the goods in only one market! a firm has to

sell its products in different markets. If consumers in one market desert a product! it can

cover the losses in other markets.

5i7ersification of source of supply ) Instead of buying raw materials and other inputs

from only one source! it is better to purchase them from different sources. If one person

fails to supply! a firm can buy from several sources.

5i7ersification of t!e process of *anufacture ) Instead adopting only one process of

production to manufacture a commodity! it is better to use different processes or methods

to produce the same commodity so as to avoid the loss arising out of the failure of any

one process.

II. )$ternal )cono*ies or Pecuniary )cono*ies

0"ternal economies are those economies hich accrue to the firms as a result of

the e"pansion in the output of hole industry and they are not dependent on the output le!el

of indi!idual firms . These economies or gains will arise on account of the overall growth of an

industry or a region or a particular area. They arise due to benefit of locali#ation and speciali#ed

progress in the industry or region.

Prof. 3tonier $ 'ague points out that e"ternal economies are those economies in

production which depend on increase in the output of the whole industry rather than increase in

the output of the individual firm The following are some of the important aspect of e"ternaleconomies.

:. They arise Voutside1 the firm.

;. They arise due to improvement in e"ternal factors.


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B. They arise due to overall development! e"pansion $ growth of an industry or a region.

. They are dependent on the si#e of industry.

K. They are beyond the control of management of a firm.

J. They are called as open secrets of a firm.

3. .3 ;inds of )$ternal )cono*ies

1. )cono*ies of concentration or Agglo*eration

They arise because in a particular area a !ery large number of firms hich

produce the same commodity are established. In other words! this is an advantage which arises

from what is called V+ocali#ation of Industry1.

The following benefits of locali#ation of industry is enjoyed by all the firms

provision of better and cheap labor at low or reasonable rates! trained educated and skilled labor!

transport and communication! water! power! raw materials financial assistance through private

and public institutions at low interest rates! marketing facilities! benefits of common repairs!

maintenance and service shops! services of specialists or outside e"perts! better use of

byproducts and other such benefits. Thus! it helps in reducing the cost of operation of a firm.

2. )cono*ies of Infor*ation

These economies ill arise as a result of getting %uic#, latest and up to dateinformation from !arious sources. Another form of benefit that arises due to locali#ation of

industry is economies of information. 3ince a large number of firms are located in a region! it

becomes possible for them to e"change their views fre uently! to have discussions with others! to

organi#e lectures! symposiums! seminars! workshops! training camps! demonstrations on topics

of mutual interest.

@evolution in the field of information technology! e"pansion in inter net

facilities! mobile phones! emails! video conferences! etc has helped in the free flow of latest

information from all parts of the globe in a very short span of time. 3imilarly! publication of

journals! maga#ines! information papers etc have helped a lot in the dissemination of uick

information. 3tatistical! technical and other market information becomes more readily available

to all firms. This will help in developing contacts between different firms. %hen inter0firm

relationship strengthens! it helps a lot to economi#e the e"penditure of a single firm.

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3. )cono*ies of 5isintegration

These economies ill arise as a result of di!iding one big unit in to different

small units for the sa#e of con!enience of management and administration. %hen an industry

grows beyond a limit! in that case! it becomes necessary to split it in to small units. /ew

subsidiary units may grow up to serve the needs of the main industry. (or e"ample! in cotton

te"tiles industry! some firms may speciali#e in manufacturing threads! a few others in printing!

and some others in dyeing and coloring etc. This will certainly enhance the efficiency in the

working of a firm and cut down unit costs considerably.

. )cono*ies of @o7ern*ent Action

These economies ill arise as a result of acti!e support and assistance gi!en by

the go!ernment to stimulate production in the pri!ate sector units. In recent years the

government! in order to encourage the development of private industries have come up with

several kinds of assistance. It is granting ta" concessions! ta" holidays! ta" e"emptions!

subsidies! development rebates financial assistance at low interest rates! etc.

It is uite clear from the above detailed description that both internal and

e"ternal economies arise on account of large scale production and they are benefits to a firm and

cost reducing in nature.

0. )cono*ies of P!ysical Factors

These economies ill arise due to the a!ailability of fa!orable physical factors

and en!ironment. As the si#e of an industry e"pands! positive physical environment may to

reduce the costs of all firms working in the industry. (or e"ample! &limate! weather conditions!

fertility of the soil! physical environment in a particular place may help all firms to enjoy certain

physical benefits.

8. )cono*ies of elfare

These economies ill arise on account of !arious elfare programs under

ta#en by an industry to help its o n staff. A big industry is in a better position to provide

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welfare facilities to the workers. It may get land at concessional rates and procure special

facilities from the local governments for setting up housing colonies for the workers. It may also

establish health care units! training centers! computer centers and educational institutions of all

types. It may grant concessions to its workers. All these measures would help in raising the

overall efficiency and productivity of workers.

3. . 5isecono*ies of 'cale

%hen a firm e"pands beyond the optimum limit! economies of scale will be

converted in to diseconomies of scale. ,ver growth becomes a burden. 'ence! one should not

cross the limit. ,n account of diseconomies of scale! more output is obtained at higher cost of

production.

The following are some of the main diseconomies of scale

1. Financial disecono*ies=

As there is over growth! the re uired amount of fiancWe may not be available

to a firm. &onse uently! higher interest rates are to be paid for additional funds .

2. Managerial disecono*ies= *"cess growth leads to loss of effective supervision! control management!

coordination of factors of production leading to all kinds of wastages! indiscipline and rise in

production and operating costs.

3. Mar+eting disecono*ies=

Mnplanned e"cess production may lead to mismatch between demand and

supply of goods leading to fall in prices. 3tocks may pile up! sales may decline leading to fall in

revenue and profits.

. (ec!nical disecono*ies=

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%hen output is carried beyond the plant capacity! per unit cost will certainly go

up. There is a limit for division of labor and speciali#ation. =eyond a point! they become

negative. 'ence! operation costs would go up.

0. 5isecono*ies of ris+ and uncertainty &earing=

If output e"pends beyond a limit! investment increases. The level of inventory

goes up. 3ales do not go up correspondingly. =usiness risks appear in all fields of activities.

3upply of factor inputs become inelastic leading to high prices.

8. a&or disecono*ies=

An unwieldy firm may become impersonal. &ontact between labor and

management may disappear. %orkers may demand higher wages and salaries! bonus and other such benefits etc. Industrial disputes may arise. +abor unions may not cooperate with the

management. All of them may contribute for higher operation costs.

II )$ternal disecono*ies. %hen several business units are concentrated in only place or

locality! it may lead to congestion!! environmental pollution! scarcity of factor inputs like! raw

materials! water! power! fuel! transport and communications etc leading to higher production and

operational costs.

Thus! it is very clear that a firm can enjoy benefits of large scale production only

up to a limit. =eyond the optimum limit! it is bound to e"perience diseconomies of scale. 'ence!

there should be proper check on the growth and e"pansion of a firm.

3. .0 Internalisation of )$ternal )cono*ies

It implies that a firm will convert certain e"ternal benefits created by the

government or the entire society to its own favor with out making any additional investments. A

firm may start a new unit in between two big railway stations or near the air port or near the

national high ways or a port so that it can enjoy all the infrastructure benefits. 3imilarly! a new

computer firm can commence its operations where there is ;G hours supply of electricity. 'ence!

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they are also called as privati#ation of public benefits. 3uch type of efforts is to be encouraged by

the government.

3. .8 )$ternalisation of Internal 5isecono*ies

In this case! a particular firm on account of its regular operations will pass on

certain costs on the entire society. A firm instead of taking certain precautionary measures by

spending some amount of money will escape and pass on this burden to the government or the

society.

(or e"ample! a firm may throw chemical or industrial wastes! dirt and filth either

to open air or rivers leading to environmental pollution. In that case! the government is forced to

spend more money to clean river water or prevent environmental pollution. This is a clear case of

e"ternali#ed internal diseconomies. It is to be avoided at all costs.

3.0 Production opti*i>ation

Benefits

:. An accurate forecast of future cash flows and associated risks

;. &ost savings by avoiding unnecessary attention to areas that are non0critical! and

improved focus on areas of higher value


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. A road map on how to improve production capacities and production availability based

on risk and cost0benefit assessments.

I*portant para*eters include

a. Production capacity profiles

b. ?emand profiles and product prices

c. Physical asset layout and design

d. * uipment reliability performance

e. Daintenance and repair activities including spare part strategies

f. ,peration and mobilisation activities.

3.8 Iso


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The prime concern of a firm is to workout the cheapest factor combinations to

produce a given uantity of output. There are a large number of alternative combinations of

factor inputs which can produce a given uantity of output for a given amount of investment.

'ence! a producer has to select the most economical combination out of them. Isoproduct curve

is a techni ue developed in recent years to show the e uilibrium of a producer with two variable

factor inputs. It is a parallel concept to the indifference curve in the theory of consumption.

3.8.2 M)A I @ A 5 5)FI I(I '

The term Iso Quant has been derived from Iso meaning e!ua" and Quant meaning

!uantit#. $ence, Iso Quant is a"so ca""ed as %!ua" Product &urve or Product Indifference

&urve or &onstant Product &urve. An Iso 'roduct curve re'resents a"" the 'ossib"e

combinations of two factor in'uts which are ca'ab"e of 'roducing the same "eve" of out'ut. It

ma# be defined as a curve which shows the different combinations of the two in'uts

'roducing the same "eve" of out'ut .

%ach Iso Quant curve re'resents on"# one 'articu"ar "eve" of out'ut. If there are different

IsoQuant curves, the# re'resent different "eve"s of out'ut. An# 'oint on an IsoQuant curve

re'resents same "eve" of out'ut. (ince each 'oint indicates e!ua" "eve" of out'ut, the 'roducer

becomes indifferent with res'ect to an# one of the combinations.

!at are Iso


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:. It is generally assumed that there are only two factors or inputs of production.

;. The factors of production are divisible into small units and can be used in any proportion.


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Figure refer !ard copy

An iso uant map where 4< O 4; O 4:. A typical choice of inputs would be labor

for input 9 and capital for input L. Dore of input 9! input L! or both is re uired to move from

iso uant 4: to 4;! or from 4; to 4


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3.8. '!apes of Isoan unchanging rate. The perfect substitute inputs do not e"perience decreasing marginal rates ofreturn when they are substituted for each other in the production function.

If the two inputs are perfect complements! the iso uant map takes the form of

fig. =2 with a level of production 4

the certain ratio occurring at the kink in the iso uant. The firm will combine the two inputs in the

re uired ratio to ma"imi#e profit.

Iso uants are typically combined with isocost lines in order to solve a cost0

minimi#ation problem for given level of output. In the typical case shown in the top figure! with

smoothly curved iso uants! a firm with fi"ed unit costs of the inputs will have isocost curves that

are linear and downward sloped2 any point of tangency between an iso uant and an isocost curve

represents the cost0minimi#ing input combination for producing the output level associated with

that iso uant.

The only relevant portion of the iso uant is the one that is conve" to the origin!

part of the curve which is not conve" to the origin implies negative marginal product for factorsof production. 'igher I3,04uant higher the production

Iso


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combination he uses for producing the same level of output. It is in this way that an iso product

curve is also called Sproduction indifference curveS. In the figure :;.:! I3, product IP curve

represents the various combinations of the two inputs which produce the same level of output

-:CC meters of cloth .

Iso


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This implies that the Iso uant is a negatively sloped curve. This is because

when the uantify of factor 6 -capital is increased! the uantity of + -labor must be reduced so

as to keep the same level of output. The figure -:;.< depicts that an iso uant IP is negatively

sloped curve. This curve shows that as the amount of factor 6 is increased from one unit to ;

units! the units of factor + are decreased from ;C to :B only so that output of :CC units remains

constant.

ii An Iso


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output! when the techni ue of production remains unchanged. 'ence two iso uants cannot

intersect each other.

i7 (!e iso


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)$planation of Isocost ines

An isocost line is also called outlay line or price line or factor cost line. An

isocost line shows all the combinations of labor and capital that are available for a given total

cost to0the producer. ust as there are infinite number of iso uants! there are infinite number ofisocost lines! one for every possible level of a given total cost. The greater the total cost! the

further from origin is the isocost line.

The isocost line can be e"plained easily by taking a simple e"ample.

+et us e"amine a firm which wishes to spend Y:CC on a combination of

two factors labor and capital for producing a given level of output. %e suppose further that the

price of one unit of labor is YB per day. This means that the firm can hire ;C units of labor. ,n

the other hand if the price of capital is Y:C per unit! the firm will purchase :C units of capital. In

the fig. :;.K! the point A shows :C units of capital used whereas point T shows ;C units of labor

are hired at the given price. If we join points A and T! we get a line AT. This AT line is called

isocost line or outlay line. The isocost line is obtained with an outlay of Y:CC.

+et us assume now that there is no change in the market prices of the two

factors labor and capitaZ but the firm increases the total outlay to Y:BC. The new price line =6

shows that with an outlay of Y:BC! the producer can purchase :B units of capital or


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-: +inear Iso uant

-; There is perfect substitutability of inputs.

-< @ight angle Iso uant

G. &onve" Iso uant

B. * ual Product curves

1. inear iso


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e.g. A shirt can be made with more wastage of cloth when less care -less labour is

used.-&:

If more is spent on labour! the shirt can be made with less cloth! wastage being less.-&;

If still more care is taken by spending more on labour! minimum wastage is done! by

using still lesser amount of cloth.-&< &onve" Iso uant &loth.

*conomic @egion of an Iso uant %hen relatively small amount of a factor

is combined with relatively large amount of another factor in an iso0 uant! in such a manner that

the marginal productivity of this abundant factor tends to be negative! resulting in decline in total

output. In such cases! the end portions of the curves are regarded as uneconomical. Thus when

e"tended on either side! the iso0 uants are oval shaped.

*conomic region of the iso0 uant is determined by drawing tangents to the

curves parallel to the two a"es! and the points of tangency indicate #ero marginal productivity of

the abundant factor. *conomic @egion ?ifference between * ual Product &urve -Iso uant and

Indifference &urve Indifference &urves

Indifference curves indicate level of satisfaction.

Indifference curves relate to combinations between two commodities.

Indifference curves cannot be labelled easily as there is no numerical measurement of the

satisfaction involved.

,n indifference map! between higher and lower indifference curve! the e"tent of

difference in the satisfaction is not uantifiable.

0. )


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,n e ual product map! we can measure the e"act difference between output represented

by one iso0 uant and another iso0 uant. &obb0?ouglas Production (unction &obb0

?ouglas production function relates output in American Danufacturing industries to

labour and capital inputs! taking the form P 5 a-+b&:0b 7a and b are Fve constants. P 5

total output -production + 5 inde" of labour employed in manufacturing & 5 inde" of

fi"ed capital in manufacturing b and :0b are elasticities of production representing

percentage response of output to percentage changes in labour and capital. The above

stated production function is a linear and homogeneous function of degree! one which

establishes constant returns to scale.

Managerial uses of production function

In microeconomics! a production function asserts that the ma"imum output

of a technologically0determined production process is a mathematical production of input factors

of production. &onsidering the set of all technically feasible combinations of output and inputs!

only the combinations encompassing a ma"imum output for a specified set of inputs would

constitute the production function.

Alternatively! a production function can be defined as the specification of the

minimum input re uirements needed to produce designated uantities of output! given available

technology. It is usually presumed that uni ue production functions can be constructed for every

production technology.

=y assuming that the ma"imum output technologically possible from a given

set of inputs is achieved! economists using a production function in analysis are abstracting away

from the engineering and managerial problems inherently associated with a particular production

process. The engineering and managerial problems of technical efficiency are assumed to be

solved! so that analysis can focus on the problems of allocative efficiency.

The firm is assumed to be making allocative choices concerning how much of

each input factor to use! given the price of the factor and the technological determinants

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commodity. The compensation is the cost. The value of inputs re uired in the production of a

commodity determines its cost of output.

2ost of production refers to the total money e"penses 34oth e"plicit and implicit5 incurred by

the producer in the process of transforming inputs into outputs.

In short! it refers total money e"penses incurred to produce a particular uantity

of output by the producer. The knowledge of various concepts of costs! cost output relationship

etc. occupies a prominent place in cost analysis.

3.9.1 Managerial Uses of Cost Analysis

A detailed study of cost analysis is very useful for managerial decisions. It helps

the management

:. To find the most profitable rate of operation of the firm.

;. To determine the optimum uantity of output to be produced and supplied.


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:. Money Cost and /eal Cost

6hen cost is e"pressed in terms of money, it is called as money cost. It relates

to money outlays by a firm on !arious factor inputs to produce a commodity. In a monetary

economy! all kinds of cost estimations and calculations are made in terms of money only.

.'ence! the knowledge of money cost is of great importance in economics. *"act measurement

of money cost is possible.

6hen cost is e"pressed in terms of physical or mental efforts put in by a

person in the ma#ing of a product, it is called as real cost. It refers to the physical! mental or

psychological efforts! the e"ertions! sacrifices! the pains! the discomforts! displeasures and

inconveniences which various members of the society have to undergo to produce a commodity.

It is a subjective and relative concept and hence e"act measurement is not possible.

2. I*plicit or I*puted Costs and )$plicit Costs

0"plicit costs are those costs hich are in the nature of contractual

payments and are paid by an entrepreneur to the factors of production 7e"cluding himself8 in

the form of rent, ages, interest and profits, utility e"penses, and payments for ra materials

etc. They can be estimated and calculated e"actly and recorded in the books of accounts. Implicit

or imputed costs are implied costs. They do not take the form of cash outlays and as such do not

appear in the books of accounts. They are the earnings of o ner employed resources.

(or e"ample! the factor inputs owned by the entrepreneur himself like capital

can be utili#ed by him0self or can be supplied to others for a contractual sum if he himself does

not utili#e them in the business. It is to be remembered that the total cost is a sum of both

implicit and e"plicit costs.

3. Actual costs and pportunity Costs

Actual costs are also called as outlay costs! absolute costs and ac uisition costs.

They are those costs that involve financial e"penditures at some time and hence are recorded in

the books of accounts. They are the actual e"penses incurred for producing or ac%uiring a

commodity or ser!ice by a firm.

(or e"ample! wages paid to workers! e"penses on raw materials! power!

fuel and other types of inputs. They can be e"actly calculated and accounted without any

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difficulty. Opportunity cost of a good or ser!ice is measured in terms of re!enue hich could

ha!e been earned by employing that good or ser!ice in some other alternati!e uses.

In other words! opportunity cost of anything is the cost of displaced

alternatives or costs of sacrificed alternatives. It implies that opportunity cost of anything is the

alternati!e that has been foregone. 'ence! they are also called as alternative costs. ,pportunity

cost represents only sacrificed alternatives. 'ence! they can never be e"actly measured and

recorded in the books of accounts.

The knowledge of opportunity cost is of great importance to management

decision. They help in taking a decision among alternatives. %hile taking a decision among

several alternatives! a manager selects the best one which is more profitable or beneficial by

sacrificing other alternatives.(or e"ample! a firm may decide to buy a computer which can do the work of

:C laborers. If the cost of buying a computer is much lower than that of the total wages to be paid

to the workers over a period of time! it will be a wise decision. ,n the other hand! if the total

wage bill is much lower than that of the cost of computer! it is better to employ workers instead

of buying a computer. Thus! a firm has to take a number of decisions almost daily.

. 5irect costs and indirect costs

9irect costs are those costs hich can be specifically attributed to a

particular product, a department, or a process of production.

(or e"ample! e"penses on raw materials! fuel! wages to workers! salary to a

divisional manager etc are direct costs. ,n the other hand! indirect costs are those costs! which

are not traceable to any one unit of operation. They cannot be attributed to a product! a

department or a process.

(or e"ample! e"penses incurred on electricity bill! water bill! telephone bill!

administrative e"penses etc.

0. Past and future costs.

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Past costs are those costs which are spent in the previous periods. ,n the

other hand! future costs are those which are to be spent. in the future. Past helps in taking

decisions for future.

8. Marginal and Incre*ental costs

Darginal cost refers to the cost incurred on the production of another or

one more unit . It implies additional cost incurred to produce an additional unit of output It has

nothing to do with fi"ed cost and is always associated with variable cost. Incremental cost on the

other hand refers to the costs involved in the production of a batch or group of output. They are

the added costs due to a change in the level or nature of business activity.

(or e"ample! cost involved in the setting up of a new sales depot in another

city or cost involved in the production of another :CC e"tra units.

9. Fi$ed costs and 7aria&le costs.

Fi"ed costs are those costs hich do not !ary ith either e"pansion or

contraction in output. They remain constant irrespecti!e of the le!el of output . They are

positive even if there is no production. They are also called as supplementary or over head costs.

,n the other hand! !ariable costs are those costs hich directly and

proportionately increase or decrease ith the le!el of output produced . They are also called as

prime costs or direct costs.

?. Accounting costs and econo*ic costs.

&ccounting costs are those costs hich are already incurred on the

production of a particular commodity. It includes only the ac uisition costs. They are the actual

costs involved in the making of a commodity. ,n the other hand! economic costs are those costs

that are to be incurred by an entrepreneur on !arious alternati!e programs. It involves the

application of opportunity costs in decision making.

3.9.3 5eter*inants of Costs

&ost behavior is the result of many factors and forces. =ut it is very difficult to

determine in general the factors influencing the cost as they widely differ from firm to firm and

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even industry to industry. 'owever! economists have given some factors considering them as

general determinants of costs. They have enough importance in modern business set up and

decision making process.

The following factors deserve our attention in this connection.

1. (ec!nology

Dodern technology leads to optimum utili#ation of resources! avoid all

kinds of wastages! saving of time! reduction in production costs and resulting in higher output.

,n the other hand! primitive technology would lead to higher production costs.

2 . /ate of output= t!e degree of utili>ation of t!e plant and *ac!inery

&omplete and effective utili#ation of all kinds of plants and e uipments wouldreduce production costs and under utili#ation of e"isting plants and e uipments would lead to

higher production costs.

3. 'i>e of Plant and scale of production

enerally! speaking big companies with huge plants and machineries organi#e

production on large scale basis and enjoy the economies of scale which reduce the cost per unit.

. Prices of input factors

'igher market prices of various factor inputs result in higher cost of production

and vice0versa.

0. )fficiency of factors of production and t!e *anage*ent

'igher productivity and efficiency of factors of production would lead to lower

production costs and vice versa.

8. 'ta&ility of output

3tability in production would lead to optimum utili#ation of the e"isting capacity

of plants and e uipments. It also brings savings of various kinds of hidden costs of interruption

and learning leading to higher output and reduction in production costs.

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9. a# of returns

Increasing returns would reduce cost of production and diminishing returns

increase cost.

?. (i*e period

In the short run! cost will be relatively high and in the long run! it will be low as

it is possible to make all kinds of adjustments and readjustments in production process. Thus!

many factors influence cost of production of a firm.

3.? Cost utput

/elations!ip= Cost Function.

&ost and output are correlated. &ost output relations play an important role in

almost all business decisions. It throws light on cost minimi#ation or profit ma"imi#ation and

optimi#ation of output. The relation bet een the cost and output is technically described as the

2OST F:;2TIO;. The significance of cost output relationship is so great that in economic

analysis the cost function usually refers to the relationship between cost and rate of output alone

and we assume that all other independent variables are kept constant. Dathematically speaking

T& 5 f -4 where T& 5 Total cost and 4 stands for output produced.

'owever! cost function depends on three important variables.

1 Production function

If a firm is able to produce higher output with a little uantity of inputs! in that

case! the cost function becomes cheaper and vice0versa.

2. (!e *ar+et prices of inputs

If market prices of different factor inputs are high in that case! cost function

becomes higher and vice0versa.

3. Period of ti*e

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&ost function becomes cheaper in the long run and it would be relatively costlier

in the short run.

(ypes of cost function.

enerally speaking there are two types of cost functions.

:. 3hort run cost function.

;. +ong run cost function.

/elations!ip and Cost cur7es in t!e '!ort-/un .

It is interesting to note that the relationship between the cost and output isdifferent at two different periods of time i.e. short run and long run. enerally speaking! cost of

production will be relatively higher in the short run when compared to the long run. This is

because a producer will get enough time to make all kinds of adjustments in the productive

process in the long run than in the short run.

%hen cost and output relationship is represented with the help of diagrams! we

get short run and long run cost curves of the firm. /ow we shall make a detailed study of cost

out put relations both in the short0run as well as in the long run.

3.?.1 M)A I @ F ' /( /U

Short-run is a period of time in hich only the !ariable factors can be !aried hile fi"ed

factors li#e plant, machinery etc remains constant .

'ence! the plant capacity is fi"ed in the short run. The total number of firms in an

industry will remain the same. Time is insufficient either for the entry of new firms or e"it of theold firms. If a firm wants to produce greater uantities of output! it can do so only by employing

more units of variable factors or by having additional shifts! or by having over time work for the

e"isting labor force or by intensive utili#ation of e"isting stock of capital assets etc. 'ence! short

run is defined as a period where adjustments to changed conditions are only partial.

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The short run cost function relates to the short run production function. It implies

two sets of input components 8

-a (i"ed inputs and

-b >ariable inputs.

(i"ed inputs are unalterable. They remain unchanged over a period of time. ,n the

other hand! variable factors are changed to vary the output in the short run.

Thus! in the short period some inputs are fi"ed in amount and a firm can e"pand or

contract its output only by changing the amounts of other variable inputs. The cost output

relationship in the short run refers to a particular set of conditions where the scale of operation is

limited by the fi"ed plant and e uipment. 'ence! the costs of the firm in the short run are divided

into fi"ed cost and variable costs. %e shall study these two concepts of costs in some detail

1. Fi$ed costs

These costs are incurred on fi"ed factors li#e land, buildings, e%uipments, plants, superior

type of labor, top management etc. Fi"ed costs in the short run remain constant because the

firm does not change the size of plant and the amount of fi"ed factors employed.

Fi$ed costs do not 7ary #it! eit!er e$pansion or contraction in output .

These costs are to be incurred by a firm even output is #ero. *ven if the firm close down its

operation for some time temporarily in the short run! but remains in business! these costs have to

be borne by it. 'ence! these costs are independent of output and are referred to as unavoidable

contractual cost.

Prof. Darshall called fi"ed costs as supplementary costs. They include such items

as contractual rent payment! interest on capital borrowed! insurance premiums! depreciation and

maintenance allowances! administrative e"penses like manager1s salary or salary of the

permanent staff! property and business ta"es! license fees! etc. They are called as overhead costs

because these costs are to be incurred whether there is production or not. These costs are to bedistributed on each unit of output produced by a firm. 'ence! they are called as indirect costs.

2. %aria&le costs

The cost corresponding to !ariable factors are discussed as !ariable costs. These costs are

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incurred on ra materials, ordinary labor, transport, po er, fuel, ater etc, hich directly

!ary in the short run.

>ariable costs directly and proportionately increase or decrease with the level of

output. If a firm shuts down for some time in the short run2 then it will not use the variable

factors of production and will not therefore incur any variable costs. >ariable costs are incurred

only when some amount of output is produced. Total variable costs increase with increase in the

level of production and vice0versa.

Prof. Darshall called variable costs as prime costs or direct costs because the

volume of output produced by a firm depends directly upon them. It is clear from the above

description that production costs consist of both fi"ed as well as variable costs. The difference

between the two is meaningful and relevant only in the short run. In the long run all costs become variable because all factors of production become adjustable and variable in the long

run.

'owever! the distinction between fi"ed and variable costs is very significant in

the short run because it influences the average cost behavior of the firm. In the short run! even if

a firm wants to close down its operation but wants to remain in business! it will have to incur

fi"ed costs but it must cover at least its variable costs.

Cost output relations!ip and nature and &e!a7ior of cost cur7es in t!e s!ort

run In order to study the relationship between the level of output and corresponding cost of

production! we have to prepare the cost schedule of the firm.

& cost schedule is a statement of a !ariation in costs resulting from !ariations

in the le!els of output. It sho s the response of cost to changes in output. A hypothetical cost

schedule of a firm has been represented in the following table.

utput

in Units

FC (%C (C AFC A%C AC MC

C < C 0 < C 0 0 0 0: < C :JC BGC < C :JC BGC :JC; < C ;GC CC :JC :;C


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< C & is as follows. T>& 5 T&T(&.

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T>& 5 f -4 i.e. T>& is an increasing function of out put.

In other words T>& varies with output. It is nil! if there is no production. Thus!

it is a direct cost of output. T>& rises sharply in the beginning! gradually in the middle and

sharply at the end in accordance with the law of variable proportion. The law of variable

proportion e"plains that in the beginning to obtain a given uantity of output! relative variation in

factors needed are in less proportion! but after a point when the diminishing returns operate!

variable factors are to be employed in a larger proportion to increase the same level of output.

T>& curve slope upwards from left to right.

T>& curve rises as output is e"panded. %hen out put is [ero! T>& also will be

#ero. 'ence! the T>& curve starts from the origin.

(%CD(C-(FC

FI@U/) refer !ard copy

3. (otal cost (C

The total cost refers to the aggregate money e"penditure incurred by a

firm to produce a gi!en %uantity of output. The total cost is measured in relation to the

production function by multiplying the factor prices with their uantities. T& 5 f -4 which

means that the T.&. varies with the output. Theoretically speaking T& includes all

unit -3 production cost analysis

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