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PROCESS PROCESS
Production is a process in which Production is a process in which
economics resources or inputs are economics resources or inputs are
combined by entrepreneurs to combined by entrepreneurs to
create economic goods and create economic goods and
services services
THE PRODUCTÌON FUNCTÌON THE PRODUCTÌON FUNCTÌON
The task of a production unit is to The task of a production unit is to
organise organise a production process a production process  a a
process of combining the different process of combining the different
factors in some proportion so that factors in some proportion so that
those inputs can be efficiently those inputs can be efficiently
transformed into products or transformed into products or
outputs. outputs.
The production function The production function
INPUTS INPUTS
Factors Factors
Factors of Factors of
production production
Resources Resources
OUTPUTS OUTPUTS
Quantity (Q) Quantity (Q)
Total product(P) Total product(P)
Product Product
Mathematical statements Mathematical statements
Q=f(X Q=f(X
11
,X ,X
2 2
...........................X ...........................X
KK
) )
Where Q=Output, X Where Q=Output, X
11
....X ....X
22
=Inputs used =Inputs used
For the purpose of analysis, the equation can be reduced to two inputs X For the purpose of analysis, the equation can be reduced to two inputs X
and Y. and Y.
Q=f(X,Y) Q=f(X,Y)
Where Q=output Where Q=output
X=Labour X=Labour
Y=Capital Y=Capital
The production function defines the relationship The production function defines the relationship
between inputs and the maximum amount that between inputs and the maximum amount that
can be produced within a given period of time can be produced within a given period of time
with a given level of tecnology with a given level of tecnology
The Nature of production The Nature of production
1. 1. The production function is purely The production function is purely
technological. technological.
2. 2. Production function is a continuous Production function is a continuous
function function
3. 3. Production function has economic Production function has economic
importance importance
4. 4. Production functions differ from firm Production functions differ from firm
to firm and industry to industry to firm and industry to industry
Ksta(s sl s(siastss
lasstss
a(s¡ tsssssss
ssssms mss(tssss
sstsasas lasstss
lls( l(sm
l(m ts l(m
Types of production function Types of production function
1. 1. Fixed proportion and variable Fixed proportion and variable
proportion production function proportion production function
2. 2. Short period and long period Short period and long period
production function production function
3. 3. Cobb Cobb Douglas production function. Douglas production function.
%s l\si s(sss(tss s(siastss lasstss
's(ss s(sss(tss s(siastss lasstss
s

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

 I I ¦ + ¦ ä I e

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+
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When outlay is increased prices of factors When outlay is increased prices of factors
remaining unchanged, factor combination will remaining unchanged, factor combination will
change with more quantities of factors being change with more quantities of factors being
purchased. For each increase in total outlay the purchased. For each increase in total outlay the
isocost lines will be different and shift upwards. isocost lines will be different and shift upwards.
Prices of factors remaining unchanged the isocost Prices of factors remaining unchanged the isocost
lines will have parallel shifts. lines will have parallel shifts.
Properties of isoquants Properties of isoquants
1 1 Isoquants are convex to origin: The slope of the isoquant Isoquants are convex to origin: The slope of the isoquant
measures, the marginal rate of technical substitution of measures, the marginal rate of technical substitution of
one factor input(say labour) for other factor input(say one factor input(say labour) for other factor input(say
capital). capital).
2 Isoquants are negative slope: This means that in order to 2 Isoquants are negative slope: This means that in order to
maintain a given level of output when the amount of one maintain a given level of output when the amount of one
factor input is increased other must be decreased. factor input is increased other must be decreased.
3 Isoquants never intersect each other: This is necessary 3 Isoquants never intersect each other: This is necessary
because by definition each isoquant represents a specific because by definition each isoquant represents a specific
quatum quatum of output. Therefore if two isoquants intersect of output. Therefore if two isoquants intersect
each other it would involve logical contradiction as each other it would involve logical contradiction as
particular isoquant at time may be representing a small as particular isoquant at time may be representing a small as
well as a large quantity of output. well as a large quantity of output.
4 Isoquants never touch axis: Isoquants do not intercept either 4 Isoquants never touch axis: Isoquants do not intercept either
axis because if it touches it would mean that output is axis because if it touches it would mean that output is
possible by using single factor, but this is unrealistic. possible by using single factor, but this is unrealistic.
5 Sometimes isoquants are oval shape: One isoquant may have 5 Sometimes isoquants are oval shape: One isoquant may have
positive upwards slope at its ends. When with relatively positive upwards slope at its ends. When with relatively
small amount of factor small amount of factor realtive realtive large amount of factor is large amount of factor is
combined marginal productivity of abundant tends to be combined marginal productivity of abundant tends to be
negative and as such resulting in decline of total output. In negative and as such resulting in decline of total output. In
such cases the end positions of curves are called such cases the end positions of curves are called
uneconomical. uneconomical.
Marginal rate of technical Marginal rate of technical
substitution (MRTS) substitution (MRTS)
The producers substitute are input in the place of The producers substitute are input in the place of
other in the production process. The substituting other in the production process. The substituting
of one input for another without changing the of one input for another without changing the
level of output is called as marginal rate of level of output is called as marginal rate of
technical substitution. The scope of isoquant is technical substitution. The scope of isoquant is
measured in terms of MRTS. The MRTS of factor measured in terms of MRTS. The MRTS of factor
x( x(labour labour) for a unit of factor (y) which can be ) for a unit of factor (y) which can be
subsituted subsituted or replaced for a unit of x without or replaced for a unit of x without
changing the level of output. The terms of inputs changing the level of output. The terms of inputs
(K) and labour (L). (K) and labour (L).
MRTS is similar to MRC marginal rate MRTS is similar to MRC marginal rate
of substitution in indifference curve of substitution in indifference curve
analysis MRTS dimnishes always. analysis MRTS dimnishes always.
EQUÌLÌBRÌUM OF THE FÌRM EQUÌLÌBRÌUM OF THE FÌRM
CHOÌCE OF OPTÌMAL CHOÌCE OF OPTÌMAL
COMBÌNATÌON OF FACTORS COMBÌNATÌON OF FACTORS
producer or a firm is said to be in equilibrium producer or a firm is said to be in equilibrium
when it is able to produce more output with when it is able to produce more output with
given outlay and given factors of production. given outlay and given factors of production.
rational producer may attain equilibrium either rational producer may attain equilibrium either
by by maxmising maxmising output for a given cost or output for a given cost or
minimising minimising cost subject to a given level of cost subject to a given level of
output. In order to determine the producers output. In order to determine the producers
equilibrium we should equilibrium we should intergrate intergrate an isoquant an isoquant
map with map with isocost isocost line. line.
n isoquant is the locus of all combinations of n isoquant is the locus of all combinations of
two factors of production that yield same level of two factors of production that yield same level of
satisfaction. Isoquant map refers to a group of satisfaction. Isoquant map refers to a group of
isoquants each representing different levels of isoquants each representing different levels of
output. n output. n isocost isocost line represents various line represents various
combinations of two inputs that may be combinations of two inputs that may be
purchased for a given amount of expenditure. purchased for a given amount of expenditure.
Maximisation of output for a Maximisation of output for a
given cost. given cost.
rational producer will always try to rational producer will always try to maxmise maxmise his his
output for given cost. This can explained with the output for given cost. This can explained with the
help of a diagram. Suppose the producers cost help of a diagram. Suppose the producers cost
outlay is C and the prices of capital and labour outlay is C and the prices of capital and labour
are ` are `i i´ and `w´ respectively. Subject to these cost ´ and `w´ respectively. Subject to these cost
conditions the producer would attempt to attain conditions the producer would attempt to attain
the maximum output level. the maximum output level.
OPTÌMAL FACTOR OPTÌMAL FACTOR
COMBÌNATÌON TO MAXÌMÌSE COMBÌNATÌON TO MAXÌMÌSE
OUTPUT LEVEL. OUTPUT LEVEL.
K
\
A
B B
B (BBB)
BZ (ZBBB)
BB (BBBB)
aaar
B
A
P

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A

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Let AB in the figure represents given cost outIay .IQ1,IQ2,IQ3 Let AB in the figure represents given cost outIay .IQ1,IQ2,IQ3
are isoquants representing three different IeveIs of output are isoquants representing three different IeveIs of output
IQ3 IeveI of output is not attainabIe because it is out of reach IQ3 IeveI of output is not attainabIe because it is out of reach
of producer .In fact any output IeveI beyond of producer .In fact any output IeveI beyond isocost isocost Iine AB Iine AB
is not attainabIe .The producer firm reaches equiIibrium is not attainabIe .The producer firm reaches equiIibrium
position at point E at this stage he empIoys OK amount of position at point E at this stage he empIoys OK amount of
capitaI and OL of Iabour. capitaI and OL of Iabour.
The aim of producer is to maximize his output with given cost The aim of producer is to maximize his output with given cost
outIay he wiII prefer onIy point E and not any other point on outIay he wiII prefer onIy point E and not any other point on
isocost isocost Iine. Iine.
Minimisation of cost for a Minimisation of cost for a
given level of output given level of output
The producer or the firm may minimize the The producer or the firm may minimize the
cost of producing a given amount of output. In cost of producing a given amount of output. In
both the cases the condition of equilibrium both the cases the condition of equilibrium
remains the same. That is the MRTS must be remains the same. That is the MRTS must be
equal to factor price ratio. equal to factor price ratio.
MRTS MRTS
LK LK
=w/ =w/i i=P =P
l l
/ /P P
kk
Where, W=wages (price for labour) Where, W=wages (price for labour)
i i=interest (price for capital) =interest (price for capital)
p p
l l
=Price of labour =Price of labour
p p
kk
=price of capital =price of capital
 


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of of isocost isocost lines representing various levels of total cost lines representing various levels of total cost
outlay (A outlay (A
11
BB
11
, A , A
22
BB
22
, A , A
33
BB
33
).The ).The isocost isocost lines Here , we have lines Here , we have
one isoquant representing given level of output( one isoquant representing given level of output(i.e i.e 2000 2000
units) and a set are parallel, and thus have the same scope units) and a set are parallel, and thus have the same scope
because they have been drawn on the assumption of because they have been drawn on the assumption of
constant price of factors. constant price of factors.
The The iso isocost line,AB is not relevant because the output level cost line,AB is not relevant because the output level
represent by the represent by the iso isoquant IQ quant IQ
22
(i.e. 2000units) is not (i.e. 2000units) is not
producing by any factor combination 'F' and 'G' on A producing by any factor combination 'F' and 'G' on A
33
BB
3 3
isocost isocost line. But he can also produce the same level of line. But he can also produce the same level of
output at point 'E' (equilibrium) on A output at point 'E' (equilibrium) on A
22
BB
22
isocost isocost line at a line at a
lower cost. Since the producer's aim is lower cost. Since the producer's aim is to minimize the cost, to minimize the cost,
he will choose the point 'E' rather than 'F' and 'G' because he will choose the point 'E' rather than 'F' and 'G' because
these two points lie on the higher cost outlay. Therefore, these two points lie on the higher cost outlay. Therefore,
the producer by employing OK of capital and OL of labour the producer by employing OK of capital and OL of labour
can reach the equilibrium 'E' by minimizing the cost for a can reach the equilibrium 'E' by minimizing the cost for a
stipulated output (2000 units). stipulated output (2000 units).
EXPANSION PATH: (Choice of optimaI EXPANSION PATH: (Choice of optimaI
expansion path) expansion path)
hen the financial resources of a firm increases, hen the financial resources of a firm increases,
it would like to increase its output. The output it would like to increase its output. The output
can be increased if there is no increase in the can be increased if there is no increase in the
cost of the factors. In other words, the output cost of the factors. In other words, the output
produced by a firm increases with increase in produced by a firm increases with increase in
its financial resources. By using different its financial resources. By using different
combinations of factors(inputs) a firm can combinations of factors(inputs) a firm can
produce different levels of output. Among produce different levels of output. Among
these, the combination of factors which is these, the combination of factors which is
optimum will be used by the firm and it is optimum will be used by the firm and it is
called as " called as "Expantion Expantion path". It is also called as path". It is also called as
'scale 'scaleline' . According to Stonier and Hague line' . According to Stonier and Hague
" "Expantion Expantion path is that line which reflects least path is that line which reflects least
cost method of producing different levels of cost method of producing different levels of
output". output".

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Units of labour employed is measured along the X axis and capital Units of labour employed is measured along the X axis and capital
employed is measured along the Y axis. The first employed is measured along the Y axis. The first iso iso cost line of the cost line of the
firm is AB. Ìt is tangent to ÌQ at point 'E', which is the initial equilibrium firm is AB. Ìt is tangent to ÌQ at point 'E', which is the initial equilibrium
of the firm. Supposing the price per unit of labour and capital remains of the firm. Supposing the price per unit of labour and capital remains
unchanged and the financial resources of the firm increases, the firm's unchanged and the financial resources of the firm increases, the firm's
new new iso iso cost line shifts to right as CD. Ìn this situation new cost line shifts to right as CD. Ìn this situation new iso iso cost line cost line
CD will be parallel to the initial CD will be parallel to the initial iso iso cost line AB and tangent to ÌQ cost line AB and tangent to ÌQ
2 2
at at
point E point E
2 2
which will be the new equilibrium point now. Ìf the financial which will be the new equilibrium point now. Ìf the financial
resources of the firm further increases, but the price of the factors resources of the firm further increases, but the price of the factors
remaining the same, the remaining the same, the iso iso cost line will be FG. Ìt will be tangent to cost line will be FG. Ìt will be tangent to
the the iso iso quant ÌQ quant ÌQ
3 3
at point E at point E
3 3
which will be the new equilibrium point which will be the new equilibrium point
of the firm. By joining all the equilibrium points we get a line(PP) called of the firm. By joining all the equilibrium points we get a line(PP) called
scale scale line or expansion path. Ìt is called so because a firm expands its line or expansion path. Ìt is called so because a firm expands its
output or scale of production in conformity with this line. output or scale of production in conformity with this line.
COST MINIMISATION COST MINIMISATION
The firm wants to produces any amount The firm wants to produces any amount
of output at the least cost. This is of output at the least cost. This is
obtained by point of tangency of the obtained by point of tangency of the
isoquant to an ISO cost line. In other isoquant to an ISO cost line. In other
words, minimum cost mean that words, minimum cost mean that
Isoquants are tangents to ISO cost Isoquants are tangents to ISO cost
lines. lines.
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Ìn the above diagram the maximum output is Ìn the above diagram the maximum output is
obtained at a point of tangency between isoquant obtained at a point of tangency between isoquant
and ÌSO cost lines. N,M,L are the points of tangency. and ÌSO cost lines. N,M,L are the points of tangency.
The firm expands output along the line D. At the The firm expands output along the line D. At the
point of N output, the firm buys OX point of N output, the firm buys OX

and OY and OY

inputs. inputs.
This is the optimal combination of inputs. At this This is the optimal combination of inputs. At this
point, the marginal rate of substitution between point, the marginal rate of substitution between
inputs is equal to the ratio between the prices of the inputs is equal to the ratio between the prices of the
inputs. The minimum cost represented by the point inputs. The minimum cost represented by the point
of tangency between the isoquant and ÌSO cost line., of tangency between the isoquant and ÌSO cost line.,
Uses of production function Uses of production function
1. 1. To know least To know least cost combination. cost combination.
2. 2. To maxmise production. To maxmise production.
3. 3. To attain equilibrium. To attain equilibrium.
4. 4. Helps in decision making. Helps in decision making.
5. 5. Basis for production planning. Basis for production planning.
Production function one variabIe input:Short run Production function one variabIe input:Short run
anaIysis(Law of variabIe proportion) anaIysis(Law of variabIe proportion)
The law of variable proportion occupies very The law of variable proportion occupies very
important place in ME because it examines the important place in ME because it examines the
production function with one variable input production function with one variable input
keeping the other inputs fixed when quantities of keeping the other inputs fixed when quantities of
one input is varied keeping other inputs constant one input is varied keeping other inputs constant
the proportion between fixed factor and variable the proportion between fixed factor and variable
factor is altered when combination of inputs are factor is altered when combination of inputs are
thus altered the resulting output changes .The thus altered the resulting output changes .The
effect of output of variations in factor proportions effect of output of variations in factor proportions
is called law of variable proportions. is called law of variable proportions.
The law states that "as more and more of factor The law states that "as more and more of factor
input is employed all other input quantities input is employed all other input quantities
remaning constant a point will eventually be remaning constant a point will eventually be
reached where additional quantities of varying reached where additional quantities of varying
input will yeild deminishing contributions to total input will yeild deminishing contributions to total
products ". products ".
Assumptions Assumptions
1. 1. The state of technology of production The state of technology of production
remains unchanged remains unchanged
2. 2. Some inputs are kept fixed during the Some inputs are kept fixed during the
process of production.It is only in this process of production.It is only in this
way that factors proportions are way that factors proportions are
altered to know its effect on output altered to know its effect on output
3. 3. The law is based on the possibility of The law is based on the possibility of
varying proportion in which various varying proportion in which various
factors can be combined to produce a factors can be combined to produce a
product. product.
Ìllustrations of law Ìllustrations of law
No of No of
workers workers
(x) (x)
output(o) output(o)
verage verage
product product
o/y o/y
Marginal Marginal
Product Product
Stages Stages
11
22
33
88
17 17
27 27
88
8.5 8.5
99
88
99
10 10
Increasing Increasing
returns returns II
44
55
66
77
36 36
43 43
48 48
48 48
99
8.6 8.6
88
6.8 6.8
99
77
55
00
Decreasin Decreasin
g returns g returns 
II II
88 46 46 5.7 5.7  22 Negative Negative
Returns Returns II II
From total output average output can From total output average output can
be derived. Marginal product is the be derived. Marginal product is the
addition to total product which can be addition to total product which can be
produced by addition of more units of produced by addition of more units of
variable input. verage output is the variable input. verage output is the
ratio of total output to amount of ratio of total output to amount of
variable input. The behaviour of the variable input. The behaviour of the
total average and marginal output is total average and marginal output is
shown in the diagram. shown in the diagram.
Ìncreasing returns stage: Ìncreasing returns stage:
In this stage 1 total product increases at an In this stage 1 total product increases at an
increasing rate. Two men produce more than twice increasing rate. Two men produce more than twice
as one man. In this stage both marginal product as one man. In this stage both marginal product
(MP) and average product (P) are rising. Because (MP) and average product (P) are rising. Because
MP is greater than P MP pulls up the average MP is greater than P MP pulls up the average
product. The boundary line of 1 stage is reached product. The boundary line of 1 stage is reached
when P and MP are equal. This takes place at the when P and MP are equal. This takes place at the
point N in the diagram. The first stage is known as point N in the diagram. The first stage is known as
the stage of increasing returns, because the P of the stage of increasing returns, because the P of
the variable factor is increasing throughout the the variable factor is increasing throughout the
period. period.
Decreasing returns stage Decreasing returns stage
In the stage II,The total product contines to In the stage II,The total product contines to
increase,but at a diminishing rate. hen the increase,but at a diminishing rate. hen the
marginal product is zero,the total product is the marginal product is zero,the total product is the
maximum. In this stage both AP & MP are maximum. In this stage both AP & MP are
declining. MP being below the average declining. MP being below the average
product,pulls the agerage product down. At the product,pulls the agerage product down. At the
end of the second stage at the poing M,the end of the second stage at the poing M,the
marginal product to the variable product inputs marginal product to the variable product inputs
become zero,while the total point reaches the become zero,while the total point reaches the
heighest point. This stage is called the stage of heighest point. This stage is called the stage of
deminishing returns as both the average and deminishing returns as both the average and
marginal products of the variable factor marginal products of the variable factor
continuously fall. continuously fall.
Negative returns stage Negative returns stage
In the stage III,total product declines and therefore In the stage III,total product declines and therefore
the total product curve slopes downword. s a the total product curve slopes downword. s a
result,the marginal product is negative and the result,the marginal product is negative and the
MP curve goes below OX axis. The average MP curve goes below OX axis. The average
product decreases still further. It shows that the product decreases still further. It shows that the
variable factor is toomuch to mixed factor. This variable factor is toomuch to mixed factor. This
stage is called the stage for negative returns. stage is called the stage for negative returns.
It may be noted that the stage I and III are It may be noted that the stage I and III are
completely symmetrical. In the stage I,fixed completely symmetrical. In the stage I,fixed
factor is toomuch relative to the variable factor. factor is toomuch relative to the variable factor.
In this stage marginal product of the fixed factor In this stage marginal product of the fixed factor
is negative. On the other hand,in the stage is negative. On the other hand,in the stage
III,variable factor is toomuch relative to the fixed III,variable factor is toomuch relative to the fixed
factor. Therefore marginal product of the variable factor. Therefore marginal product of the variable
product is negative. product is negative.
The stage of operation The stage of operation
The question is which stage of operation is rational to production. The question is which stage of operation is rational to production.
rational producer will not choose to produce in the stage III. t rational producer will not choose to produce in the stage III. t
the end of stage II at the point M,the marginal product and thus the end of stage II at the point M,the marginal product and thus
will be making the maximum use of the variable factor. In the will be making the maximum use of the variable factor. In the
stage I,the producer will not be making maximum use of fixed stage I,the producer will not be making maximum use of fixed
factor and he will not be utilising fully the opportunities of factor and he will not be utilising fully the opportunities of
increasing production by increasing the quantity of variable increasing production by increasing the quantity of variable
product,whose average product continues to raise throughout product,whose average product continues to raise throughout
the stage I. Thus a rational producer will not stop in the stage the stage I. Thus a rational producer will not stop in the stage
I,but will expand further. t point N the marginal product to the I,but will expand further. t point N the marginal product to the
variable factor is the maximum and the end point N of the stage variable factor is the maximum and the end point N of the stage
I,he will be making maximum use of the fixed factor. So long as I,he will be making maximum use of the fixed factor. So long as
the average product,marginal product and total product are the average product,marginal product and total product are
raising,the entrepreneur will not stop producing. Therefore he raising,the entrepreneur will not stop producing. Therefore he
goes to stage II,where both marginal product and the average goes to stage II,where both marginal product and the average
product of the variable factor are deminishing. The stage II product of the variable factor are deminishing. The stage II
represents the range of rational production decisions. represents the range of rational production decisions.
The laws of returns to scale(Long run) The laws of returns to scale(Long run)
The laws production describe the technically The laws production describe the technically
possible ways of increasing the level of possible ways of increasing the level of
production. These show how the input can be production. These show how the input can be
increased by changing the quantities of factor increased by changing the quantities of factor
inputs. In the short run only one factor can be inputs. In the short run only one factor can be
altered, keeping the other factor unchanged. It altered, keeping the other factor unchanged. It
is because ,in the short period, fixed factors is because ,in the short period, fixed factors
like machinery cannot be altered. But it is like machinery cannot be altered. But it is
possible to alter the fixed factors in the long possible to alter the fixed factors in the long
period. The laws of returns to the scale refers period. The laws of returns to the scale refers
to the long run analysis of production. to the long run analysis of production.
The laws of returns to scale are entairly different from the laws The laws of returns to scale are entairly different from the laws
of variable proportion. Ìn the laws of returns to the scale,all of variable proportion. Ìn the laws of returns to the scale,all
productive factors or inputs are increased or decreased in the productive factors or inputs are increased or decreased in the
same proportion simeltaneously. Ìn returns to scale,we analyses same proportion simeltaneously. Ìn returns to scale,we analyses
the effect of doubling or tribling,quadrupling and so on of all the effect of doubling or tribling,quadrupling and so on of all
inputs from the output of the product. The study of changes in inputs from the output of the product. The study of changes in
the output as a consequence of changes in the scale,forms the the output as a consequence of changes in the scale,forms the
subject matter of 'returns to scale subject matter of 'returns to scale'. '.
The three phases of returns to scale The three phases of returns to scale
Producers who have not studied economic analysis Producers who have not studied economic analysis
think that output can be doubled by doubling all the think that output can be doubled by doubling all the
inputs or trible the output by tribling all the inputs or trible the output by tribling all the
productive inputs. But actually this is not so. In productive inputs. But actually this is not so. In
other words,actually the output are returns donot other words,actually the output are returns donot
increase/decrease strictly according to the change in increase/decrease strictly according to the change in
the scale. the scale.
If the increase in the output is proportional to If the increase in the output is proportional to
increase in the quantities of input,returns to scale increase in the quantities of input,returns to scale
are said to be constant. It means that a doubling of are said to be constant. It means that a doubling of
inputs causes a doubling of output. If the increase in inputs causes a doubling of output. If the increase in
output is more than the proportional,returns to scale output is more than the proportional,returns to scale
are increasing and if the increase in output is less are increasing and if the increase in output is less
than proportional,returns to scale to scale re than proportional,returns to scale to scale re
deminishing. deminishing.
Returns to scale Returns to scale
S.No. S.No. Scale of inputs Scale of inputs Total Total
product product
Marginal Marginal
product product
or or
returns returns
Stage Stage
11
22
33
44
1 worker + 3 acres of 1 worker + 3 acres of
land land
2 workers + 6 acres of 2 workers + 6 acres of
land land
3 workers + 9 acres of 3 workers + 9 acres of
land land
4 workers + 12 acres 4 workers + 12 acres
22
55
99
14 14
22
33
44
55
Increasing Increasing
returns returns II
55
66
5 worker + 15 acres 5 worker + 15 acres
6 worker + 18 acres 6 worker + 18 acres
19 19
24 24
55
55
Constant Constant
returns returns II II
77
88
99
7 worker + 21 acres 7 worker + 21 acres
8 worker + 24 acres 8 worker + 24 acres
9 worker + 27 acres 9 worker + 27 acres
28 28
31 31
33 33
44
33
22
Diminishing Diminishing
returns returns III III
IIIustration IIIustration
In the table,it can be sean that as all the factor In the table,it can be sean that as all the factor
inputs are together increased to the same extent,the inputs are together increased to the same extent,the
marginal product or returns increases first up to a marginal product or returns increases first up to a
point then constant for some further increase in the point then constant for some further increase in the
scale and ultimately starts declining. t the s.cale of 1 scale and ultimately starts declining. t the s.cale of 1
workers +30 acres of land,the total product is 2 workers +30 acres of land,the total product is 2
quintals. To increase the output,the scale is quintals. To increase the output,the scale is
doubled,the total increases to more than double(5 doubled,the total increases to more than double(5
quintals instead of 2 quintals). When the output is quintals instead of 2 quintals). When the output is
tribled,the output increaes to 9 quintals,the increase tribled,the output increaes to 9 quintals,the increase
this time being 4 quintals instead of 3 quintals. In this time being 4 quintals instead of 3 quintals. In
other words,the return to scale is increasing. If the other words,the return to scale is increasing. If the
scale of production is further increased,the marginal scale of production is further increased,the marginal
product remains constant upto a certain point and product remains constant upto a certain point and
behyond it,it starts deminishing. behyond it,it starts deminishing.
Increasing returns to scaIe Increasing returns to scaIe
Increasing returns to scale means that output increases in a Increasing returns to scale means that output increases in a
great proportion than increase in inputs.If for example all great proportion than increase in inputs.If for example all
inputs are increased by 25 percent,the output increases by 40 inputs are increased by 25 percent,the output increases by 40
percent,then the increasing returns to scale is percent,then the increasing returns to scale is
prevaililng.When the firm is expanding ,increasing returns to prevaililng.When the firm is expanding ,increasing returns to
scale obtained in the beginning.One chief reason for this scale obtained in the beginning.One chief reason for this
increase is the effect of technical and managerial increase is the effect of technical and managerial
indivisibility.Indivisibility means that equipment is available indivisibility.Indivisibility means that equipment is available
only in minimum sizes and the firm has to start producing only in minimum sizes and the firm has to start producing
from the minimum size of equipment.In the beginning the from the minimum size of equipment.In the beginning the
firm will not be in a position to use the equipment to its firm will not be in a position to use the equipment to its
optimum capacity.In other words ,the equipments are under optimum capacity.In other words ,the equipments are under 
utilized in the beginning.When the scale of operations are utilized in the beginning.When the scale of operations are
increased,they are input into maximum use and hence the increased,they are input into maximum use and hence the
output are return increases more than proportiionately. output are return increases more than proportiionately.
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Constant returns to scale Constant returns to scale
If the scale of inputs are increased in a given If the scale of inputs are increased in a given
proportion and the output increases in the same proportion and the output increases in the same
proportion,returns to scale are said to be proportion,returns to scale are said to be
constant,that is doubling of all inputs,doubls the constant,that is doubling of all inputs,doubls the
output. In mathematics the case of constant returns output. In mathematics the case of constant returns
to scale is called lenier and homogeneous production to scale is called lenier and homogeneous production
function or homogeneous production function of the function or homogeneous production function of the
first degree. In some industries,expansion of output first degree. In some industries,expansion of output
produces no net economies are diseconomies and the produces no net economies are diseconomies and the
cost of production remains the same. cost of production remains the same.
Such industries said to be goverened by the law of Such industries said to be goverened by the law of
constant returns. constant returns.
Diminishing returns to scale Diminishing returns to scale
When the output increases in smaller proportion than When the output increases in smaller proportion than
the increase in all inputs,decreasing returns to scale is the increase in all inputs,decreasing returns to scale is
said to prevail. When firm goes on expanding by said to prevail. When firm goes on expanding by
increasing all its inputs,then eventually diminishing increasing all its inputs,then eventually diminishing
returns to scale occur.economists give different cause returns to scale occur.economists give different cause
for diminishing returns some economists view that the for diminishing returns some economists view that the
enterpreneur is one fixed,while all other inputs are enterpreneur is one fixed,while all other inputs are
variable factors. But the enterpreneur factor cannot be variable factors. But the enterpreneur factor cannot be
increased. On this view they say that the law of increased. On this view they say that the law of
diminishing returns is the special case of the law of diminishing returns is the special case of the law of
variable proportions. In this case they say that we get variable proportions. In this case they say that we get
diminishing returns beyond a point,because varying diminishing returns beyond a point,because varying
quantities of all other inputs are combined with the quantities of all other inputs are combined with the
enterpreneur as a fixed factor. Other economists do not enterpreneur as a fixed factor. Other economists do not
subscribe to this view but they say that diminishing subscribe to this view but they say that diminishing
returns to scale occur because of increasing difficulties returns to scale occur because of increasing difficulties
of management, coordination and control. When the of management, coordination and control. When the
firm becomes gigantic, it is difficult to manage it with firm becomes gigantic, it is difficult to manage it with
the efficiency as before. the efficiency as before.
Empirical production function Empirical production function
There are five types of linear and There are five types of linear and
non non linear models of production linear models of production
functions used in empirical studies. functions used in empirical studies.
>> LINER PRODUCTION FUNCTION. LINER PRODUCTION FUNCTION.
>> QUDRTIC PRODUCTION FUNCTION. QUDRTIC PRODUCTION FUNCTION.
>> CUBIC PRODUCTION FUNCTION. CUBIC PRODUCTION FUNCTION.
>> POWER PRODUCTION FUNCTION. POWER PRODUCTION FUNCTION.
>> COBB DOUGLS PRODUCTION COBB DOUGLS PRODUCTION
FUNCTION FUNCTION..
Linear production function. Linear production function.
This is the simplest form of production This is the simplest form of production
function. In the short run it stated as function. In the short run it stated as
follows: follows:
Q=b Q=b
00
+b +b
11
V Where V Where
Q= Output Q= Output
b b
00
=fixed factor input =fixed factor input
BB
11
= slope coefficient = slope coefficient
V = variable factor V = variable factor
Graphically the production function can Graphically the production function can
be represented by a straight line be represented by a straight line
'
/=M

The value of "b The value of "b
0 0
¨ intercept parameter in the ¨ intercept parameter in the
shortrun production function refers to the fixed shortrun production function refers to the fixed
factor input quantity "b factor input quantity "b
1 1
' the slope coefficient ' the slope coefficient
represents the marginal product (MP) the represents the marginal product (MP) the
variable factor. Ìt being constant also variable factor. Ìt being constant also
represents the average product (AP). As such represents the average product (AP). As such
AP=MP when MP is constant, the marginal AP=MP when MP is constant, the marginal
and average product curves are horizontal and average product curves are horizontal
straight lines, which tend to coincide. straight lines, which tend to coincide.
Quadratic production function Quadratic production function
It is stated as follows It is stated as follows
Q=b Q=b
00
+b +b
11
VV b b
22
VV
22
This equation measures downward slope of the P This equation measures downward slope of the P
and MP curves as shown below. It is useful to know and MP curves as shown below. It is useful to know
the quantum diminishing returns. the quantum diminishing returns.

'
/
M
Cubic production function Cubic production function
It is stated as follows It is stated as follows
Q=b Q=b
00
+b +b
11
V+b V+b
22
VV
22
 b b
33
VV
33
This function highlights the law of non proportional returns to This function highlights the law of non proportional returns to
the variable factors. Graphically it shows that the marginal the variable factors. Graphically it shows that the marginal
product(MP) curve is initially raising and then falling. lso product(MP) curve is initially raising and then falling. lso
the MP curve intersects the P curve at its maximum point the MP curve intersects the P curve at its maximum point..
Power production function Power production function
It is stated as follows It is stated as follows
Q=aV Q=aV
b b
where Q=the output where Q=the output
a=constant parameter a=constant parameter
b=power b=power
V=variable factor input V=variable factor input
Logarithmically, its linear form is as follows Logarithmically, its linear form is as follows
log(Q) = log(aV log(Q) = log(aV
b b
) )
log Q = log a + log (V log Q = log a + log (V
b b
) )
log Q = log a + b log V log Q = log a + b log V
Cobb Cobb Douglas production function Douglas production function
ll the above stated production considered a ll the above stated production considered a
single variable factor at a time. The Cobb single variable factor at a time. The Cobb 
Douglas production function considers two Douglas production function considers two
variables factor inputs. The Cobb variables factor inputs. The Cobb Douglas Douglas
functional form of production function is functional form of production function is
widely used to represent the relationship of widely used to represent the relationship of
output to inputs. For production the output to inputs. For production the
function is function is
Y=L Y=L
d d
kk
ß ß
Where Y=Output, L=Labour input, K=Capital Where Y=Output, L=Labour input, K=Capital
input input
, ,d d,,ß ß =Constant determined by technology. =Constant determined by technology.
If If d d+ +ß ß =1 the production function has constant =1 the production function has constant
returns to scale. That is if L and K are each returns to scale. That is if L and K are each
increased by 20% Y increases by 20%. increased by 20% Y increases by 20%.
If If d d+ +ß ß <1 the returns to scale are decreasing. <1 the returns to scale are decreasing.
If If d d+ +ß ß >1 the returns to scale are increasing. >1 the returns to scale are increasing.
ssuming perfect competition a and can be shown ssuming perfect competition a and can be shown
to be labours and capital´s share of output. to be labours and capital´s share of output.
The exponents a and are output The exponents a and are output elasticities elasticities with with
respect to labour and capital respectively. Output respect to labour and capital respectively. Output
elasticity measures the responsiveness of output to elasticity measures the responsiveness of output to
a change on labour or capital used in production, a change on labour or capital used in production,
other things remaining equal. For example if a=1.5 other things remaining equal. For example if a=1.5
a 1% increase in labour would lead to approximately a 1% increase in labour would lead to approximately
a 1.5% increase in output. a 1.5% increase in output.
Cobb and Douglas were influenced by statistical Cobb and Douglas were influenced by statistical
evidence that appeared to show that the labour and evidence that appeared to show that the labour and
capital share of output were constant over a period capital share of output were constant over a period
time in developed countries they explained this by time in developed countries they explained this by
statistical fitting least squares regression of their statistical fitting least squares regression of their
production function. Its transformation into linear form production function. Its transformation into linear form
by using logarithms is as follows: by using logarithms is as follows:
Log + Log +d dLog L+ Log L+ß ßLog K. Log K.
The common form of Cobb Douglas function used in The common form of Cobb Douglas function used in
Macro economic modeling is Macro economic modeling is
Y=K Y=K
d d
LL
11  ß ß
where K is capital and L is labour. When where K is capital and L is labour. When
the model coefficient sum to one as above, the the model coefficient sum to one as above, the
production function is first order homogenous, which production function is first order homogenous, which
implies returns to scale that is if all the inputs are implies returns to scale that is if all the inputs are
doubled the output is doubled. doubled the output is doubled.
In the Cobb Douglas function, elasticity of substitution In the Cobb Douglas function, elasticity of substitution
between capital and labour that is capital can be between capital and labour that is capital can be
interchanged with labour without affecting output. interchanged with labour without affecting output.
CES PRODUCTÌON FUNCTÌON CES PRODUCTÌON FUNCTÌON
Proposed by merican economist Kenneth and rrow Proposed by merican economist Kenneth and rrow
CES production function is also known as constant CES production function is also known as constant
elasticity of substitution production elasticity of substitution production function.This function.This is a is a
linear homogenous production function with constant linear homogenous production function with constant
elasticity of input substitution which takes on the form elasticity of input substitution which takes on the form
other than unity. other than unity.
It is replaced the It is replaced the cobb cobb Douglas production function Douglas production function
model which looked at physical output as a product of model which looked at physical output as a product of
labour and capital inputs labour and capital inputs
The equation for CES production function model is The equation for CES production function model is
Q=( Q=(aK aK
 b b
+(1 +(1 c)L c)L
 b b
) )
 1/b 1/b
Where Q=output ,K=capital ,L= Where Q=output ,K=capital ,L=labour labour
a,b,c a,b,c, are constants , are constants
PRODUCTÌON POSSÌBLÌTY PRODUCTÌON POSSÌBLÌTY
CURVE CURVE
n economy has a certain population and n economy has a certain population and
some millon workers of various grades, it some millon workers of various grades, it
has mastered certain techniques of has mastered certain techniques of
production, it has certain resources in the production, it has certain resources in the
form of land, water and other natural form of land, water and other natural
resources.IT has a certain number of resources.IT has a certain number of
inputs. The society has really to decide inputs. The society has really to decide
how this resources can be utilised to how this resources can be utilised to
produce the various possible commodities. produce the various possible commodities.
In other words, it has to discover its In other words, it has to discover its
production possibility curve. production possibility curve.
The production possibility curve shows the maximum The production possibility curve shows the maximum
output of any one commodity that the economy can output of any one commodity that the economy can
produce together with the prescribed quantities of other produce together with the prescribed quantities of other
commodities produced and resources utilised.Ìn short commodities produced and resources utilised.Ìn short
PPT curve tells us what assortment of goods and PPT curve tells us what assortment of goods and
services the economy can produce with the resources services the economy can produce with the resources
and techniques at its disposal. The assortment on the and techniques at its disposal. The assortment on the
curve is regarded as technologically efficient and below curve is regarded as technologically efficient and below
it as inefficient. For the simple reason that the it as inefficient. For the simple reason that the
economic is capable of producing a bigger assortment economic is capable of producing a bigger assortment
at least in respect of one commodity without at least in respect of one commodity without
decreasing any other. Any assortment which is beyond decreasing any other. Any assortment which is beyond
the frontier is really beyond the economy power and is the frontier is really beyond the economy power and is
unattainable. The PPT curve depicts the society's unattainable. The PPT curve depicts the society's
menu of choices. menu of choices.
e shall illustrate the concept of PPT curve by means of table e shall illustrate the concept of PPT curve by means of table
and a daigram. Let us take two commodities X and Y that a and a daigram. Let us take two commodities X and Y that a
firm can produce. Ìf it decides to devote more of its resouces to firm can produce. Ìf it decides to devote more of its resouces to
production X it must sacrifice to that extent production of production X it must sacrifice to that extent production of
Y.Take the following table Y.Take the following table 
Production Production
possibilities possibilities
X X
(Thousands) (Thousands)
Y Y
(thousands) (thousands)
BB
C C
DD
E E
FF
00
11
22
33
44
55
15 15
14 14
12 12
99
55
00
Let all the productive resources available devoted Let all the productive resources available devoted
to the production of Y with the result that 15,000 Y to the production of Y with the result that 15,000 Y
but no X in between these two extreme limits but no X in between these two extreme limits
there are numerous combinations of X and Y that there are numerous combinations of X and Y that
can be produced .The PPT curve can be depicted can be produced .The PPT curve can be depicted
by means of diagram given below.Ìn this diagram by means of diagram given below.Ìn this diagram
A represents the one extreme limit at which all y's A represents the one extreme limit at which all y's
are produced now if we want to produce some X are produced now if we want to produce some X
some Y will have to be sacrifice for instance in some Y will have to be sacrifice for instance in
order to produce 1000 X we shall have to be order to produce 1000 X we shall have to be
content with 14,000 Y instead of 15,000.e have content with 14,000 Y instead of 15,000.e have
transformed 1000 Y into 1000 X and so on down transformed 1000 Y into 1000 X and so on down
the table.So, PPT curve is also called as the table.So, PPT curve is also called as
Production transformation curve. Production transformation curve.
Product Y (1housands)
Ìn the diagram, the curve marks the production Ìn the diagram, the curve marks the production
possibility frontier and all points on the curve possibility frontier and all points on the curve
represent production possibility, the points represent production possibility, the points
inside the curve are attainable combinations inside the curve are attainable combinations
and those outside such as s, t are unattainable and those outside such as s, t are unattainable
combinations. Any point inside the curve combinations. Any point inside the curve
represents an under utilisation of resources or represents an under utilisation of resources or
under under employment. A fuller utilisation will shift employment. A fuller utilisation will shift
the curves outwards. Ìncrease in the resources the curves outwards. Ìncrease in the resources
at the disposal of the firm will take it to higher at the disposal of the firm will take it to higher
production possibility curve production possibility curve..
MARGÌNAL RATE OF TRANSFORMATÌON MARGÌNAL RATE OF TRANSFORMATÌON
We have seen above that in order to produce more We have seen above that in order to produce more
X we must sacrifice some Y,that is Y can be X we must sacrifice some Y,that is Y can be
transformed into X,the rate at which one transformed into X,the rate at which one
products is transformed into another is called as products is transformed into another is called as
marginal rate of transformation for instance marginal rate of transformation for instance
marginal rate of transformation between good X marginal rate of transformation between good X
and good Y is the amount of Y which has to be and good Y is the amount of Y which has to be
sacrificed for the production of X .This makes PPC sacrificed for the production of X .This makes PPC
concave in the origin.The MRT at any point on concave in the origin.The MRT at any point on
production possibility curve is given by slope of production possibility curve is given by slope of
the curve at that point. the curve at that point.
ECONOMÌC REGÌON ECONOMÌC REGÌON
PRODUCTÌON (RÌDGE LÌNES) PRODUCTÌON (RÌDGE LÌNES)
Generally production functions generate Generally production functions generate
isoquants which are convex and negatively isoquants which are convex and negatively
sloped, do not intersect each other and sloped, do not intersect each other and
higher the isoquants greater the level higher the isoquants greater the level
output. There are some production output. There are some production
functions which yield isoquants having all functions which yield isoquants having all
the properties except they are not the properties except they are not
negatively sloped segments. In other negatively sloped segments. In other
words they are positively sloped segments words they are positively sloped segments
LABOUR
C
A
P
I
T
A
L
Let us consider isoquant P3. B segment Let us consider isoquant P3. B segment
of this isoquant is positively sloped. of this isoquant is positively sloped.
Similarly other isoquants have the slope. Similarly other isoquants have the slope.
Beyond points and B this isoquant is Beyond points and B this isoquant is
positively sloped. The points where they positively sloped. The points where they
bent back upon themselves implying that bent back upon themselves implying that
they become positively sloped. The lines they become positively sloped. The lines
OK and OL joining these points are called OK and OL joining these points are called
ridge lines. They form the boundaries for ridge lines. They form the boundaries for
the economic region of production. the economic region of production.
Suppose the output represented by isoquant P3 is to be Suppose the output represented by isoquant P3 is to be
produced. For producing this quantity a minimum of OK2 produced. For producing this quantity a minimum of OK2
amount of capital is required because any smaller amount amount of capital is required because any smaller amount
will not allow the producer to attain the P3 level of output. will not allow the producer to attain the P3 level of output.
With OK2 amount OL2 amount of labour must be With OK2 amount OL2 amount of labour must be
employed.In employed.In case the producer uses an amount of labour case the producer uses an amount of labour
less than OL2 together with OK2 amount of capital his less than OL2 together with OK2 amount of capital his
output level would be lower than the one represented by output level would be lower than the one represented by
isoquant P3.This is quite normal because smaller inputs isoquant P3.This is quite normal because smaller inputs
would lead to smaller would lead to smaller output.But output.But combining labour input in combining labour input in
an amount larger than OL2 with OK2 amount of capital an amount larger than OL2 with OK2 amount of capital
would also result in output smaller than represented by would also result in output smaller than represented by
isoquant P3.In isoquant P3.In oder oder to maintain P3 level output with a to maintain P3 level output with a
larger amount has to be used. This is something no rational larger amount has to be used. This is something no rational
producer would attempt to do because it involves producer would attempt to do because it involves
uneconomic use of resources. uneconomic use of resources.
Point B on isoquant P3 represents the Point B on isoquant P3 represents the
intensive margin of labour because an intensive margin of labour because an
increase in the labour input beyond OL2 increase in the labour input beyond OL2
with fixed amount of capital input OK2 with fixed amount of capital input OK2
results in a fall of in the output level. T results in a fall of in the output level. T
this point marginal product of labour is this point marginal product of labour is
zero and thus the MRTS of labour for zero and thus the MRTS of labour for
capital is zero. This implies that at point B capital is zero. This implies that at point B
labour has been substituted for capital to labour has been substituted for capital to
the maximum extent. the maximum extent.
Similarly for producing P3 level of output a minimum of OL1 Similarly for producing P3 level of output a minimum of OL1
amount labour input in required. smaller amount of amount labour input in required. smaller amount of
labour input will not the producer to attain P3 level of labour input will not the producer to attain P3 level of
output. With OL amount OK1 amount of capital must be output. With OL amount OK1 amount of capital must be
used and any additions to capital input beyond OK1 would used and any additions to capital input beyond OK1 would
result in smaller output. Therefore the marginal product of result in smaller output. Therefore the marginal product of
capital is zero at point . This point represents intensive capital is zero at point . This point represents intensive
margin of capital because increase in the amount of capital margin of capital because increase in the amount of capital
input beyond OK1 with a fixed labour input of OL1will input beyond OK1 with a fixed labour input of OL1will
reduce rather than augment output. t point on P3 reduce rather than augment output. t point on P3
capital has been substituted for labour to the maximum capital has been substituted for labour to the maximum
extent the MRPS of capital for labour is zero which means extent the MRPS of capital for labour is zero which means
MRPS of labour for capital infinite MRPS of labour for capital infinite
The line OK connects the points of zero The line OK connects the points of zero
marginal product of capital. We have marginal product of capital. We have
designated it as upper ridge line. Similarly designated it as upper ridge line. Similarly
the line OL designated as lower ridge line the line OL designated as lower ridge line
joins the points of zero marginal product joins the points of zero marginal product
of labour. The combinations of labour and of labour. The combinations of labour and
capital inputs comprising the area capital inputs comprising the area
between ridge lines OL and OK constitute between ridge lines OL and OK constitute
the generalized stage2 of production for the generalized stage2 of production for
both the resources. These combinations both the resources. These combinations
that are relevant for production decisions. that are relevant for production decisions.
Economies of scale Economies of scale
Large scale production is economical in the sense that the Large scale production is economical in the sense that the
cost of production is low. The low cost leads to economies cost of production is low. The low cost leads to economies
of scale. of scale.
The economies of scale can be divided into two broad The economies of scale can be divided into two broad
categories as: categories as:  a) Internal economies b)External a) Internal economies b)External
economies. economies.
Internal economies are those economies which occur when Internal economies are those economies which occur when
firms size expand. They emerge within the firm itself as its firms size expand. They emerge within the firm itself as its
scale of production increases. Internal economies are the scale of production increases. Internal economies are the
function of the size of firm. function of the size of firm.
External economies are those economies which are shared External economies are those economies which are shared
by all firms in an industry or group when their size by all firms in an industry or group when their size
expands. They are available to all firms irrespective of their expands. They are available to all firms irrespective of their
size and scale of production. These economies are the size and scale of production. These economies are the
function of the size of the industry or group of industries as function of the size of the industry or group of industries as
whole. whole.
Forms of internal economies Forms of internal economies
Labour economies. Labour economies.
Technical economies Technical economies
a)Economies of superior technique a)Economies of superior technique
b)Economies of increased dimension. b)Economies of increased dimension.
c)Economies of linked process. c)Economies of linked process.
Managerial economies. Managerial economies.
Marketing economies. Marketing economies.
Financial economies Financial economies
Risk minimizing economies Risk minimizing economies
a)By diversification of output. a)By diversification of output.
b)By diversification market. b)By diversification market.
c)By diversification of sources of supply as well c)By diversification of sources of supply as well
as process of manufacturing. as process of manufacturing.
Forms of external economies Forms of external economies
Economies of localization. Economies of localization.
Economies of information or Economies of information or
technical and market intelligence. technical and market intelligence.
Economies of vertical disintegration. Economies of vertical disintegration.
Economies of byproducts. Economies of byproducts.
Diseconomies of scale Diseconomies of scale
Difficulties of management. Difficulties of management.
Difficulties of coordination. Difficulties of coordination.
Difficulties in decision making. Difficulties in decision making.
Increased risks. Increased risks.
Labour diseconomies. Labour diseconomies.
Scarcity of factor inputs. Scarcity of factor inputs.
Financial difficulties. Financial difficulties.
Marketing difficulties Marketing difficulties
Economies of scope Economies of scope
The concept of economies of scope is often The concept of economies of scope is often
somewhat used differently than the concept of somewhat used differently than the concept of
economies of scope. economies of scope.
It refers to reduction in unit cost It refers to reduction in unit cost realised realised when when
firm produces two or more products jointly rather firm produces two or more products jointly rather
than than seperately seperately..
multi product firm often experiences economies multi product firm often experiences economies
of scope. These economies exist when a firm of scope. These economies exist when a firm
produces two products together produces two products together undser undser the same the same
production facilities as against producing them production facilities as against producing them
under separate facilities. Thus : under separate facilities. Thus : 
TC(Q TC(Q
X X
,Q ,Q
Y Y
)<TC(Q )<TC(Q
X, X,
0)+TC(0 Q 0)+TC(0 Q
Y Y
) )
ÌLLUSTRATÌON ÌLLUSTRATÌON
firms total cost function is firms total cost function is
TC=200 TC=200 Q Q
X X
Q Q
Y Y
+Q +Q
X X
2 2
Q Q
Y Y
22
Where Q Where Q
X X
and and Q Q
Y Y
represent the number of units of product x represent the number of units of product x
and y. and y.
Do economies of scope exist when the firm produces 2 units of Do economies of scope exist when the firm produces 2 units of
x and 4 units of y? x and 4 units of y?
TC(Q TC(Q
X X
,Q ,Q
Y Y
)<TC(Q )<TC(Q
X, X,
0)+TC(0 Q 0)+TC(0 Q
Y Y
) )
TC(Q TC(Q
X X
,Q ,Q
Y Y
) 200 ) 200 (2)(4)+(2) (2)(4)+(2)
22
+(4) +(4)
22
=200 =200 8+4+16=212 8+4+16=212
TC(Q TC(Q
X X
,0)=200 Q ,0)=200 Q
xx
(0) (0) + Q + Q
X X
2 2
+(0) +(0)
2 2
=200 + Q =200 + Q
X X
2 2
=200+(2) =200+(2)
2 2
=204 =204
TC(0, Q TC(0, Q
Y Y
)=200 )=200 (0) (0) Q Q
Y Y
+(0) +(0)
22
+(Q +(Q
Y Y
) )
22
=200+ Q =200+ Q
Y Y
22
=200 +(4) =200 +(4)
22
=216 =216
Since (212)<(204+216) it follows that economies of scope Since (212)<(204+216) it follows that economies of scope
exist. exist.
Degree of economies of scale Degree of economies of scale
The degree of economies of scope can be measured in The degree of economies of scope can be measured in
terms of the difference in the cost of production jointly and terms of the difference in the cost of production jointly and
separately. The formula is used to measure the degree of separately. The formula is used to measure the degree of
economies of scope. economies of scope.
DES=TC(n)+TC (Bn) DES=TC(n)+TC (Bn) TC (n+Bn)/TC(n+Bn) TC (n+Bn)/TC(n+Bn)
Where, Where,
DES=degree of economies of scope. DES=degree of economies of scope.
TC(n)=Total cost of producing n units of product TC(n)=Total cost of producing n units of product
separately. separately.
TC(Bn)=Total cost of producing Bn Units of products B TC(Bn)=Total cost of producing Bn Units of products B
separately. separately.
TC(n+Bn)=Total cost of producing products and B TC(n+Bn)=Total cost of producing products and B
jointly, that is producing n units of product and Bn units jointly, that is producing n units of product and Bn units
of product of product B together. B together.
Learning curve Learning curve
Experience is the best teacher in business. Over time when Experience is the best teacher in business. Over time when
the firm accumulates its business experience it may tend to the firm accumulates its business experience it may tend to
improve its production organization methods with improve its production organization methods with
improved knowledge and experience of management and improved knowledge and experience of management and
labour used in production process. labour used in production process.
The firm´s learning experience would pay in terms of cost of The firm´s learning experience would pay in terms of cost of
production. In long run these tends to the downward shifts production. In long run these tends to the downward shifts
in the average cost curve of the firm on account of learning in the average cost curve of the firm on account of learning
experience effect that improves productive efficiency of the experience effect that improves productive efficiency of the
firm in its operations over a time. firm in its operations over a time.
Learning effect is different from scale economy effect. It is Learning effect is different from scale economy effect. It is
the difference between actual average cost and the difference between actual average cost and estimatede estimatede
average cost. It implies saving in cost . average cost. It implies saving in cost .
Economies of scale are measured through a give LC as a Economies of scale are measured through a give LC as a
change in the level of output per time period. The learning change in the level of output per time period. The learning
effect rate can be measured by using a formula: effect rate can be measured by using a formula: 
LER=[1 LER=[1 Ct Ct
11
/Ct /Ct
00
]*100 ]*100
Where , Where ,
LER=learning effect rate. LER=learning effect rate.
Ct Ct
00
=average cost in initial period (t =average cost in initial period (t
00
) increment. ) increment.
Ct Ct
1 1
=average cost in next period(t =average cost in next period(t
11
) increment. ) increment.
Incidentally the ratio Ct Incidentally the ratio Ct
11
/ Ct / Ct
0 0
is referred to as is referred to as
experience factor. experience factor.
X efficiency X efficiency
Cost economy is the major goal of a business firm. Cost economy is the major goal of a business firm.
Efficiency in production implies cost economy. n efficient Efficiency in production implies cost economy. n efficient
firm will tend to experience lower cost function. When the firm will tend to experience lower cost function. When the
efficiency improves cost function of the firm tends to shift efficiency improves cost function of the firm tends to shift
downwards. downwards.
In practice a major way of cost reduction is seen through In practice a major way of cost reduction is seen through
minimization of the wastage of resources. More wastage minimization of the wastage of resources. More wastage
implies higher cost. Low wastage means low cost. implies higher cost. Low wastage means low cost.
X efficiency is a function of management to reduce and X efficiency is a function of management to reduce and
minimize the waste of resources in operations. New minimize the waste of resources in operations. New
approaches such as Six Sigma methodology are essentially approaches such as Six Sigma methodology are essentially
meant towards attainment of X efficiency (waste meant towards attainment of X efficiency (waste
minimization as well as zero defect level) of minimization as well as zero defect level) of business firm. business firm.
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