THE PRODUCTION

PROCESS
Production is a process in which
economics resources or inputs are
combined by entrepreneurs to
create economic goods and
services
 THE PRODUCTION FUNCTION
 The task of a production unit is to
organise a production process – a
process of combining the different
factors in some proportion so that
those inputs can be efficiently
transformed into products or
outputs.
 The production function
 INPUTS  OUTPUTS

Factors Quantity (Q)

Factors of Total product(P)
production Product
Resources
 Mathematical statements
 Q=f(X1,X2 ...........................XK)
Where Q=Output, X1 …………X2 =Inputs used

For the purpose of analysis, the equation can be reduced to two inputs X
and Y.
Q=f(X,Y)
Where Q=output
X=Labour
Y=Capital

The production function defines the relationship

between inputs and the maximum amount that
can be produced within a given period of time
with a given level of tecnology
 The Nature of production
1. The production function is purely
technological.
2. Production function is a continuous
function
3. Production function has economic
importance
4. Production functions differ from
firm to firm and industry to industry
 Purely technological

Differ from Nature of production Continuous function

firm to firm
function

Economic Importance
 Types of production function
1. Fixed proportion and variable
proportion production function
2. Short period and long period
production function
3. Cobb-Douglas production function.
The fixed proportion production function
 Variable proportion production function

C
a
p y1 a

i
b 300
t y2 200
c
a y3
100
l

o
x1 x2 x3
Labour
 Production function through
Iso-Quants analysis
Iso-Quant curve
It is a concept which tells that the quantity
produced will be same inspite of variation in
production.
There may be different combination of inputs. Each
combination is called a scale of preference. Each
scale when applied will produce the same quantity
of output. Thus,
”Iso-Quant” (which means equal quantity) curve
indicates that each curve will have different scales
of preference of input which can produce the same
quantity of ouput
 ILLUSTRATION
 Two variables inputs namely capital (k)
and labour(l) are considered. Total output
is Rs 100 labour cost is Rs 10 per unit and
capital cost is Rs 30 per unit some
alternative combinations are as follows:
 Combination Capital Labour
 1 3 1
 2 2 4
 3 1 7
Plotting the above cost combination
we get the isocost line as follows

5
4
3
2
1

0 1 22 3 4 5 6 7 8
 When outlay is increased prices of factors
remaining unchanged, factor combination will
change with more quantities of factors being
purchased. For each increase in total outlay the
isocost lines will be different and shift upwards.
Prices of factors remaining unchanged the isocost
lines will have parallel shifts.
 Properties of isoquants
1 Isoquants are convex to origin: The slope of the isoquant
measures, the marginal rate of technical substitution of one
factor input(say labour) for other factor input(say capital).
2 Isoquants are negative slope: This means that in order to
maintain a given level of output when the amount of one
factor input is increased other must be decreased.
3 Isoquants never intersect each other: This is necessary
because by definition each isoquant represents a specific
quatum of output. Therefore if two isoquants intersect each
other it would involve logical contradiction as particular
isoquant at time may be representing a small as well as a
large quantity of output.
4 Isoquants never touch axis: Isoquants do not intercept either
axis because if it touches it would mean that output is
possible by using single factor, but this is unrealistic.
5 Sometimes isoquants are oval shape: One isoquant may have
positive upwards slope at its ends. When with relatively
small amount of factor realtive large amount of factor is
combined marginal productivity of abundant tends to be
negative and as such resulting in decline of total output. In
such cases the end positions of curves are called
uneconomical.
 Marginal rate of technical
substitution (MRTS)
 The producers substitute are input in the place of
other in the production process. The substituting
of one input for another without changing the
level of output is called as marginal rate of
technical substitution. The scope of isoquant is
measured in terms of MRTS. The MRTS of factor
x(labour) for a unit of factor (y) which can be
subsituted or replaced for a unit of x without
changing the level of output. The terms of inputs
(K) and labour (L).
 MRTS is similar to MRC marginal rate
of substitution in indifference curve
analysis MRTS dimnishes always.
 EQUILIBRIUM OF THE FIRM
CHOICE OF OPTIMAL
COMBINATION OF FACTORS

 A producer or a firm is said to be in equilibrium

when it is able to produce more output with
given outlay and given factors of production. A
rational producer may attain equilibrium either
by maxmising output for a given cost or
minimising cost subject to a given level of
output. In order to determine the producers
equilibrium we should intergrate an isoquant
map with isocost line.
 An isoquant is the locus of all combinations of
two factors of production that yield same level of
satisfaction. Isoquant map refers to a group of
isoquants each representing different levels of
output. An isocost line represents various
combinations of two inputs that may be
purchased for a given amount of expenditure.
 Maximisation of output for a
given cost.
 A rational producer will always try to maxmise his
output for given cost. This can explained with the
help of a diagram. Suppose the producers cost
outlay is C and the prices of capital and labour
are ‘i’ and ‘w’ respectively. Subject to these cost
conditions the producer would attempt to attain
the maximum output level.
 OPTIMAL FACTOR
COMBINATION TO MAXIMISE
OUTPUT LEVEL.

Y
A

C
IQ3 (3000)
A
E
P IQ2 (2000)
I
T IQ1 (1000)
A
L O B X
Labour
Let AB in the figure represents given cost outlay .IQ1,IQ2,IQ3
are isoquants representing three different levels of output
IQ3 level of output is not attainable because it is out of reach
of producer .In fact any output level beyond isocost line AB
is not attainable .The producer firm reaches equilibrium
position at point E at this stage he employs OK amount of
capital and OL of labour.

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
isocost line.
 Minimisation of cost for a
given level of output
 The producer or the firm may minimize the
cost of producing a given amount of output. In
both the cases the condition of equilibrium
remains the same. That is the MRTS must be
equal to factor price ratio.
 MRTS =w/i=P /P
LK l k

Where, W=wages (price for labour)

i=interest (price for capital)
pl =Price of labour
pk=price of capital
 Y

A3
C
A
P A2
F
I
T A1

A
E
L K G IQ (2000)

O L B1 B2 B3 X

LABOUR
of isocost lines representing various levels of total cost
outlay (A1B1, A2B2, A3B3).The isocost lines Here , we have
one isoquant representing given level of output(i.e 2000
units) and a set are parallel, and thus have the same scope
because they have been drawn on the assumption of
constant price of factors.

The iso-cost line,AB is not relevant because the output level

represent by the iso-quant IQ2 (i.e. 2000units) is not
producing by any factor combination ‘F’ and ‘G’ on A3B3
isocost line. But he can also produce the same level of
output at point ‘E’ (equilibrium) on A2B2 isocost line at a
lower cost. Since the producer’s aim is to minimize the cost,
he will choose the point ‘E’ rather than ‘F’ and ‘G’ because
these two points lie on the higher cost outlay. Therefore, the
producer by employing OK of capital and OL of labour can
reach the equilibrium ‘E’ by minimizing the cost for a
stipulated output (2000 units).
 EXPANSION PATH: (Choice of optimal
expansion path)

When the financial resources of a firm increases,

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

P
A
e3
e2 IQ3 (3000)
K e1 IQ2 (2000)

IQ3(1000)
P

O B D G X
LABOUR
 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
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
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
CD will be parallel to the initial iso-cost line AB and tangent to IQ2 at
point E2 which will be the new equilibrium point now. If the financial
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
the iso-quant IQ 3 at point E3 which will be the new equilibrium point
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
output or scale of production in conformity with this line.
 COST MINIMISATION

The firm wants to produces any amount

of output at the least cost. This is
obtained by point of tangency of the
isoquant to an ISO cost line. In other
words, minimum cost mean that
Isoquants are tangents to ISO cost
lines.
 Y
C3
C
A C2 B
P
I C1
L IQ3
T M
A Y N IQ2
1
L IQ3
A

O X1 D1 D 2 D3 X
LABOUR
 In the above diagram the maximum output is
obtained at a point of tangency between isoquant
and ISO cost lines. N,M,L are the points of tangency.
The firm expands output along the line D. At the
point of N output, the firm buys OX| and OY| inputs.
This is the optimal combination of inputs. At this
point, the marginal rate of substitution between
inputs is equal to the ratio between the prices of the
inputs. The minimum cost represented by the point
of tangency between the isoquant and ISO cost line.,
 Uses of production function
1. To know least-cost combination.
2. To maxmise production.
3. To attain equilibrium.
4. Helps in decision making.
5. Basis for production planning.
Production function one variable input:Short run
analysis(Law of variable proportion)
The law of variable proportion occupies very important
place in ME because it examines the production
function with one variable input keeping the other
inputs fixed when quantities of one input is varied
keeping other inputs constant the proportion
between fixed factor and variable factor is altered
when combination of inputs are thus altered the
resulting output changes .The effect of output of
variations in factor proportions is called law of
variable proportions.
The law states that “as more and more of factor input
is employed all other input quantities remaning
constant a point will eventually be reached where
additional quantities of varying input will yeild
deminishing contributions to total products “.
 Assumptions
1. The state of technology of production
remains unchanged

2. Some inputs are kept fixed during the

process of production.It is only in this
way that factors proportions are
altered to know its effect on output
3. The law is based on the possibility of
varying proportion in which various
factors can be combined to produce a
product.
 Illustrations of law
No of (x) Average Marginal Stages
workers output(o) product Product
o/y
1 8 8 8 Increasing
2 17 8.5 9 returns-I
3 27 9 10
4 36 9 9 Decreasin
5 43 8.6 7 g returns-
6 48 8 5 II
7 48 6.8 0
8 46 5.7 -2 Negative
Returns-II
 From total output average output can be
derived. Marginal product is the addition
to total product which can be produced by
addition of more units of variable input.
Average output is the ratio of total output
to amount of variable input. The
behaviour of the total average and
marginal output is shown in the diagram.
 Increasing returns stage:

In this stage 1 total product increases at an

increasing rate. Two men produce more than twice as
one man. In this stage both marginal product (MP)
and average product (AP) are rising. Because MP is
greater than AP MP pulls up the average product. The
boundary line of 1 stage is reached when AP and MP
are equal. This takes place at the point N in the
diagram. The first stage is known as the stage of
increasing returns, because the AP of the variable
factor is increasing throughout the period.
 Decreasing returns stage

In the stage II,The total product contines to

increase,but at a diminishing rate. When the
marginal product is zero,the total product is the
maximum. In this stage both AP & MP are
declining. MP being below the average
product,pulls the agerage product down. At the
end of the second stage at the poing M,the
marginal product to the variable product inputs
become zero,while the total point reaches the
heighest point. This stage is called the stage of
deminishing returns as both the average and
marginal products of the variable factor
continuously fall.
 Negative returns stage
In the stage III,total product declines and therefore the
total product curve slopes downword. As a result,the
marginal product is negative and the MP curve goes
below OX axis. The average product decreases still
further. It shows that the variable factor is toomuch
to mixed factor. This stage is called the stage for
negative returns.

It may be noted that the stage I and III are

completely symmetrical. In the stage I,fixed factor is
toomuch relative to the variable factor. In this stage
marginal product of the fixed factor is negative. On
the other hand,in the stage III,variable factor is
toomuch relative to the fixed factor. Therefore
marginal product of the variable product is negative.
 The stage of operation
The question is which stage of operation is rational to production. A
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
will be making the maximum use of the variable factor. In the
stage I,the producer will not be making maximum use of fixed
factor and he will not be utilising fully the opportunities of
increasing production by increasing the quantity of variable
product,whose average product continues to raise throughout
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
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
the average product,marginal product and total product are
raising,the entrepreneur will not stop producing. Therefore he
goes to stage II,where both marginal product and the average
product of the variable factor are deminishing. The stage II
represents the range of rational production decisions.
 The laws of returns to scale(Long run)

The laws production describe the technically

possible ways of increasing the level of
production. These show how the input can be
increased by changing the quantities of factor
inputs. In the short run only one factor can be
altered, keeping the other factor unchanged. It
is because ,in the short period, fixed factors
like machinery cannot be altered. But it is
possible to alter the fixed factors in the long
period. The laws of returns to the scale refers
to the long run analysis of production.
 The laws of returns to scale are entairly different from the laws
of variable proportion. In the laws of returns to the scale,all
productive factors or inputs are increased or decreased in the
same proportion simeltaneously. In returns to scale,we analyses
the effect of doubling or tribling,quadrupling and so on of all
inputs from the output of the product. The study of changes in
the output as a consequence of changes in the scale,forms the
subject matter of ‘returns to scale’.
 The three phases of returns to scale

Producers who have not studied economic analysis

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

If the increase in the output is proportional to

increase in the quantities of input,returns to scale
are said to be constant. It means that a doubling of
inputs causes a doubling of output. If the increase in
output is more than the proportional,returns to scale
are increasing and if the increase in output is less
than proportional,returns to scale to scale re
deminishing.
 Returns to scale
S.No. Scale of inputs Total Marginal Stage
product product
or
returns
1 1 worker + 3 acres of 2 2 Increasing
2 land 5 3 returns-I
3 2 workers + 6 acres of 9 4
4 land 14 5
3 workers + 9 acres of
land
4 workers + 12 acres
5 5 worker + 15 acres 19 5 Constant
6 6 worker + 18 acres 24 5 returns-II
7 7 worker + 21 acres 28 4 Diminishing
8 8 worker + 24 acres 31 3 returns-III
9 9 worker + 27 acres 33 2
 Illustration

In the table,it can be sean that as all the factor

inputs are together increased to the same extent,the
marginal product or returns increases first up to a
point then constant for some further increase in the
scale and ultimately starts declining. At the s.cale of 1
workers +30 acres of land,the total product is 2
quintals. To increase the output,the scale is
doubled,the total increases to more than double(5
quintals instead of 2 quintals). When the output is
tribled,the output increaes to 9 quintals,the increase
this time being 4 quintals instead of 3 quintals. In
other words,the return to scale is increasing. If the
scale of production is further increased,the marginal
product remains constant upto a certain point and
behyond it,it starts deminishing.
 Increasing returns to scale
Increasing returns to scale means that output increases in a
great proportion than increase in inputs.If for example all
inputs are increased by 25 percent,the output increases by 40
percent,then the increasing returns to scale is
prevaililng.When the firm is expanding ,increasing returns to
scale obtained in the beginning.One chief reason for this
increase is the effect of technical and managerial
indivisibility.Indivisibility means that equipment is available
only in minimum sizes and the firm has to start producing
from the minimum size of equipment.In the beginning the
firm will not be in a position to use the equipment to its
optimum capacity.In other words ,the equipments are under-
utilized in the beginning.When the scale of operations are
increased,they are input into maximum use and hence the
output are return increases more than proportiionately.
 6
Stage II
5
Marginal product

St
ag
4

eI
eI

II
ag
St

1
Marginal products or returns

0 1 2 3 4 5 6 7 8 9 10

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

Such industries said to be goverened by the law of

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

► LINEAR PRODUCTION FUNCTION.

► QUADRATIC PRODUCTION FUNCTION.
► CUBIC PRODUCTION FUNCTION.
► POWER PRODUCTION FUNCTION.
► COBB DOUGLAS PRODUCTION
FUNCTION.
 Linear production function.
This is the simplest form of production
function. In the short run it stated as
follows:
Q=b0+b1V Where
Q= Output
b0=fixed factor input
B1= slope coefficient
V = variable factor
Graphically the production function can
be represented by a straight line
Q

AP=MP

V
 The value of “b0” intercept parameter in the
shortrun production function refers to the fixed
factor input quantity “b1’ the slope coefficient
represents the marginal product (MP) the
variable factor. It being constant also
represents the average product (AP). As such
AP=MP when MP is constant, the marginal
and average product curves are horizontal
straight lines, which tend to coincide.
 Quadratic production function
It is stated as follows
Q=b0+b1V-b2V2
This equation measures downward slope of the AP
and MP curves as shown below. It is useful to know
the quantum diminishing returns.
Q

AP

MP

V
 Cubic production function
It is stated as follows
Q=b0+b1V+b2V2-b3V3
This function highlights the law of non proportional returns to
the variable factors. Graphically it shows that the marginal
product(MP) curve is initially raising and then falling. Also
the MP curve intersects the AP curve at its maximum point.
 Power production function
It is stated as follows
Q=aVb
where Q=the output
a=constant parameter
b=power
V=variable factor input
Logarithmically, its linear form is as follows
log(Q) = log(aV b)
log Q = log a + log (Vb)
log Q = log a + b log V
 Cobb-Douglas production function
All the above stated production considered a
single variable factor at a time. The Cobb-
Douglas production function considers two
variables factor inputs. The Cobb-Douglas
functional form of production function is
widely used to represent the relationship of
output to inputs. For production the
function is
Y=ALαkβ
Where Y=Output, L=Labour input, K=Capital
input
A,α,β =Constant determined by technology.
 If α+β =1 the production function has constant
returns to scale. That is if L and K are each
increased by 20% Y increases by 20%.
 If α+β <1 the returns to scale are decreasing.
 If α+β >1 the returns to scale are increasing.
Assuming perfect competition a and can be shown
to be labours and capital’s share of output.
 The exponents a and are output elasticities with
respect to labour and capital respectively. Output
elasticity measures the responsiveness of output to
a change on labour or capital used in production,
other things remaining equal. For example if a=1.5
a 1% increase in labour would lead to approximately
a 1.5% increase in output.
 Cobb and Douglas were influenced by statistical
evidence that appeared to show that the labour and
capital share of output were constant over a period
time in developed countries they explained this by
statistical fitting least squares regression of their
production function. Its transformation into linear form
by using logarithms is as follows:
 Log A+αLog L+βLog K.
 The common form of Cobb Douglas function used in
Macro economic modeling is
 Y=Kα L 1- β where K is capital and L is labour. When the
model coefficient sum to one as above, the production
function is first order homogenous, which implies
returns to scale that is if all the inputs are doubled the
output is doubled.
 In the Cobb Douglas function, elasticity of substitution
between capital and labour that is capital can be
interchanged with labour without affecting output.
 CES PRODUCTION FUNCTION
 Proposed by American economist Kenneth and Arrow
CES production function is also known as constant
elasticity of substitution production function.This is a
linear homogenous production function with constant
elasticity of input substitution which takes on the form
other than unity.
It is replaced the cobb Douglas production function
model which looked at physical output as a product of
labour and capital inputs
The equation for CES production function model is
Q=A(aK-b+(1-c)L-b)-1/b
Where Q=output ,K=capital ,L=labour
a,b,c, are constants
 PRODUCTION POSSIBLITY
CURVE
 An economy has a certain population and
some millon workers of various grades, it
has mastered certain techniques of
production, it has certain resources in the
form of land, water and other natural
resources.IT has a certain number of
inputs. The society has really to decide
how this resources can be utilised to
produce the various possible commodities.
In other words, it has to discover its
production possibility curve.
 The production possibility curve shows the maximum
output of any one commodity that the economy can
produce together with the prescribed quantities of other
commodities produced and resources utilised.In short
PPT curve tells us what assortment of goods and
services the economy can produce with the resources
and techniques at its disposal. The assortment on the
curve is regarded as technologically efficient and below
it as inefficient. For the simple reason that the
economic is capable of producing a bigger assortment
at least in respect of one commodity without
decreasing any other. Any assortment which is beyond
the frontier is really beyond the economy power and is
unattainable. The PPT curve depicts the society’s
menu of choices.
 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
firm can produce. If it decides to devote more of its resouces to
production X it must sacrifice to that extent production of
Y.Take the following table-

Production X Y
possibilities (Thousands) (thousands)

A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0
Let all the productive resources available devoted
to the production of Y with the result that 15,000 Y
but no X in between these two extreme limits
there are numerous combinations of X and Y that
can be produced .The PPT curve can be depicted
by means of diagram given below.In this diagram A
represents the one extreme limit at which all y’s
are produced now if we want to produce some X
some Y will have to be sacrifice for instance in
order to produce 1000 X we shall have to be
content with 14,000 Y instead of 15,000.We have
transformed 1000 Y into 1000 X and so on down
the table.So, PPT curve is also called as
Production transformation curve.
Product Y (Thousands)
In the diagram, the curve marks the production
possibility frontier and all points on the curve
represent production possibility, the points
inside the curve are attainable combinations
and those outside such as s, t are unattainable
combinations. Any point inside the curve
represents an under utilisation of resources or
under-employment. A fuller utilisation will shift
the curves outwards. Increase in the resources
at the disposal of the firm will take it to higher
production possibility curve.
 MARGINAL RATE OF TRANSFORMATION

We have seen above that in order to produce more

X we must sacrifice some Y,that is Y can be
transformed into X,the rate at which one products
is transformed into another is called as marginal
rate of transformation for instance marginal rate
of transformation between good X and good Y is
the amount of Y which has to be sacrificed for the
production of X .This makes PPC concave in the
origin.The MRT at any point on production
possibility curve is given by slope of the curve at
that point.
 ECONOMIC REGION
PRODUCTION (RIDGE LINES)
 Generally production functions generate
isoquants which are convex and negatively
sloped, do not intersect each other and
higher the isoquants greater the level
output. There are some production
functions which yield isoquants having all
the properties except they are not
negatively sloped segments. In other
words they are positively sloped segments
 CAPITAL

LABOUR
 Let us consider isoquant P3. AB segment
of this isoquant is positively sloped.
Similarly other isoquants have the slope.
Beyond points A and B this isoquant is
positively sloped. The points where they
bent back upon themselves implying that
they become positively sloped. The lines
OK and OL joining these points are called
ridge lines. They form the boundaries for
the economic region of production.
 Suppose the output represented by isoquant P3 is to be
produced. For producing this quantity a minimum of OK2
amount of capital is required because any smaller amount
will not allow the producer to attain the P3 level of output.
With OK2 amount OL2 amount of labour must be
employed.In case the producer uses an amount of labour
less than OL2 together with OK2 amount of capital his
output level would be lower than the one represented by
isoquant P3.This is quite normal because smaller inputs
would lead to smaller output.But combining labour input in
an amount larger than OL2 with OK2 amount of capital
would also result in output smaller than represented by
isoquant P3.In oder to maintain P3 level output with a
larger amount has to be used. This is something no rational
producer would attempt to do because it involves
uneconomic use of resources.
 Point B on isoquant P3 represents the
intensive margin of labour because an
increase in the labour input beyond OL2
with fixed amount of capital input OK2
results in a fall of in the output level. AT
this point marginal product of labour is
zero and thus the MRTS of labour for
capital is zero. This implies that at point B
labour has been substituted for capital to
the maximum extent.
 Similarly for producing P3 level of output a minimum of
OL1 amount labour input in required. A smaller amount of
labour input will not the producer to attain P3 level of
output. With OL amount OK1 amount of capital must be
used and any additions to capital input beyond OK1 would
result in smaller output. Therefore the marginal product of
capital is zero at point A. This point represents intensive
margin of capital because increase in the amount of capital
input beyond OK1 with a fixed labour input of OL1will
reduce rather than augment output. At point A on P3
capital has been substituted for labour to the maximum
extent the MRPS of capital for labour is zero which means
MRPS of labour for capital infinite
 The line OK connects the points of zero
marginal product of capital. We have
designated it as upper ridge line. Similarly
the line OL designated as lower ridge line
joins the points of zero marginal product
of labour. The combinations of labour and
capital inputs comprising the area between
ridge lines OL and OK constitute the
generalized stage2 of production for both
the resources. These combinations that
are relevant for production decisions.
 Economies of scale
 Large scale production is economical in the sense that the
cost of production is low. The low cost leads to economies
of scale.
 The economies of scale can be divided into two broad
categories as:- a) Internal economies b)External
economies.
 Internal economies are those economies which occur when
firms size expand. They emerge within the firm itself as its
scale of production increases. Internal economies are the
function of the size of firm.
 External economies are those economies which are shared
by all firms in an industry or group when their size
expands. They are available to all firms irrespective of their
size and scale of production. These economies are the
function of the size of the industry or group of industries
as whole.
 Forms of internal economies
 Labour economies.
 Technical economies
 a)Economies of superior technique
 b)Economies of increased dimension.
 c)Economies of linked process.
 Managerial economies.
 Marketing economies.
 Financial economies
 Risk minimizing economies
 a)By diversification of output.
 b)By diversification market.
 c)By diversification of sources of supply as well as
process of manufacturing.
 Forms of external economies

 Economies of localization.
 Economies of information or

technical and market intelligence.

 Economies of vertical disintegration.

 Economies of byproducts.
 Diseconomies of scale
 Difficulties of management.
 Difficulties of coordination.

 Difficulties in decision making.

 Increased risks.

 Labour diseconomies.

 Scarcity of factor inputs.

 Financial difficulties.

 Marketing difficulties
 Economies of scope
 The concept of economies of scope is often
somewhat used differently than the concept of
economies of scope.
 It refers to reduction in unit cost realised when
firm produces two or more products jointly rather
than seperately.
 A multi product firm often experiences economies
of scope. These economies exist when a firm
produces two products together undser the same
production facilities as against producing them
under separate facilities. Thus :-
 TC(QX ,QY )<TC(QX, 0)+TC(0 QY )
 ILLUSTRATION
 A firms total cost function is
 TC=200-QX QY +QX 2 QY2
 Where QX and QY represent the number of units of product x
and y.
 Do economies of scope exist when the firm produces 2 units of
x and 4 units of y?
 TC(QX ,QY )<TC(QX, 0)+TC(0 QY )
 TC(QX ,QY ) 200-(2)(4)+(2)2 +(4)2
 =200-8+4+16=212
 TC(QX ,0)=200 Qx (0) + QX 2 +(0)2
 =200 + QX 2 =200+(2)2 =204
 TC(0, QY )=200-(0) QY +(0)2 +(QY )2
 =200+ QY 2 =200 +(4)2=216
 Since (212)<(204+216) it follows that economies of scope
exist.
 Degree of economies of scale
 The degree of economies of scope can be measured in
terms of the difference in the cost of production jointly and
separately. The formula is used to measure the degree of
economies of scope.
 DES=TC(An)+TC (Bn)-TC (An+Bn)/TC(An+Bn)
 Where,
 DES=degree of economies of scope.
 TC(An)=Total cost of producing An units of product A
separately.
 TC(Bn)=Total cost of producing Bn Units of products B
separately.
 TC(An+Bn)=Total cost of producing products A and B
jointly, that is producing An units of product A and Bn units
of product B together.
 Learning curve
 Experience is the best teacher in business. Over time when
the firm accumulates its business experience it may tend to
improve its production organization methods with
improved knowledge and experience of management and
labour used in production process.
 The firm’s learning experience would pay in terms of cost of
production. In long run these tends to the downward shifts
in the average cost curve of the firm on account of learning
experience effect that improves productive efficiency of the
firm in its operations over a time.
 Learning effect is different from scale economy effect. It is
the difference between actual average cost and estimatede
average cost. It implies saving in cost .
 Economies of scale are measured through a give LAC as a
change in the level of output per time period. The learning
effect rate can be measured by using a formula:-
 LER=[1-ACt1 /ACt0 ]*100
 Where ,
 LER=learning effect rate.
 ACt0 =average cost in initial period (t0) increment.
 ACt1 =average cost in next period(t1) increment.
 Incidentally the ratio ACt1 / ACt0 is referred to as
experience factor.
 X efficiency
 Cost economy is the major goal of a business firm.
Efficiency in production implies cost economy. An efficient
firm will tend to experience lower cost function. When the
efficiency improves cost function of the firm tends to shift
downwards.
 In practice a major way of cost reduction is seen through
minimization of the wastage of resources. More wastage
implies higher cost. Low wastage means low cost.
 X efficiency is a function of management to reduce and
minimize the waste of resources in operations. New
approaches such as Six Sigma methodology are essentially
meant towards attainment of X efficiency (waste
minimization as well as zero defect level) of business firm.