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5.1 5.2 Introduction Objectives Meaning of production and production function 5.2.1 Uses of production function 5.2.2 Production function with one variables input case 5.2.3 Production function with two variable input 5.2.4 Long run production function 5.2.5 Economies of scale 5.2.6 Diseconomies of scale 5.2.7 Internalisation of external economies 5.2.8 Externalisation of internal diseconomies 5.2.9 Economies of scope 5.2.10 Diseconomies of scope Self Assessment Questions 1 5.3 Cost of production 5.3.1 Managerial uses of cost analysis 5.3.2 Different kinds of cost concepts 5.3.3 Determinants of costs 5.3.4 Costoutput relationship
5.3.5 Costoutput relationship and cost curves in the short run 5.3.6 Costout relationship in the long run Self Assessment Question 2 5.4 Summary Terminal Questions Answer to SAQ’s and TQ’s
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A business firm is an economic unit. It is also called as a production unit. Production is one of the most important activities of a firm in the circle of economic activity. The main objective of production is to satisfy the demand for different kinds of goods and services of the community. Learning Objectives: After studying this unit, you should be able to understand the following 1. Understand the concept of production, production function and its managerial uses. 2. Analyze short term and long term production function with illustrations. 3. Describe the various dimensions, advantages and demerits of large scale production. 4. Understand the benefits of joint production of one firm rather if it were to be produced by two different firms. 5. Meaning, different cost concepts and managerial uses of cost of production 6. Understand short run and long run costoutput relationships.
5.2. Meaning Of Production And Production Function
The concept of production can be represented in the following manner.
Entry into Firms
Exit of Firms
The term “Production” means transformation of physical “Inputs” into physical “Outputs”. The term “Inputs” refers to all those things or items which are required by the firm to produce a particular product. Four factors of production are land, labor, capital and organization. In addition to four factors of production, inputs also include other items like raw materials of all kinds, power, fuel, water, technology, time and services like transport and communications, warehousing, marketing, banking, shipping and Insurance etc. It also includes the ability, talents, capacities,
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knowledge, experience, wisdom of human beings. Thus, the term inputs have a wider meaning in economics. What we get at the end of productive process is called as “Outputs”. In short, “Outputs” refer to finished products. Production always results in either creation of new utilities or addition of values. It is an activity that increases consumer satiability of goods and services. Production is undertaken by producers and basically it depends on cost of production. Production analysis is always made in physical terms and it shows the relationship between physical inputs and physical outputs. It is to be noted that higher levels of production is an index of progress and growth of an organization and that of a society. It leads to higher income, employment and economic prosperity. Production of different types of goods and services in different nations indicates the nature of economic inter dependence between different nations. PRODUCTION FUNCTION The entire theory of production centre round the concept of production function. “A production Function” expresses the technological or engineering relationship between physical quantity of inputs employed and physical quantity of outputs obtained by a firm. It specifies a flow of output resulting from a flow of inputs during a specified period of time. It may be in the form of a table, a graph or an equation specifying maximum output rate from a given amount of inputs used. Since it relates inputs to outputs, it is also called as “Inputoutput relation.” The production is purely physical in nature and is determined by the quantum of technology, availability of equipments, labor, and raw materials, and so on employed by a firm. A production function can be represented in the form of a mathematical model or equation as Q = f (L, N, K….etc) where Q stands for quantity of output per unit of time and L N K etc are the various factor inputs like land, capital labor etc which are used in the production of output. The rate of output Q is thus, a function of the factor inputs L N K etc, employed by the firm per unit of time. Factor inputs are of two types. 1. Fixed Inputs. Fixed inputs are those factors the quantity of which remains constant irrespective of the level of output produced by a firm. For example, land, buildings, machines, tools, equipments, superior types of labor, top management etc.
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2. Variable inputs. Variable inputs are those factors the quantity of which varies with variations in the levels of output produced by a firm For example, raw materials, power, fuel, water, transport and communication etc. The distinction between the two will hold good only in the short run. In the long run, all factor inputs will become variable in nature. Short run is a period of time in which only the variable factors can be varied while fixed factors like plants, machineries, top management etc would remain constant. Time available at the disposal of a producer to make changes in the quantum of factor inputs is very much limited in the short run. Long run is a period of time where in the producer will have adequate time to make any sort of changes in the factor combinations. It is necessary to note that production function is assumed to be a continuous function, i.e. it is assumed that a change in any of the variable factors produces corresponding changes in the out put. Generally speaking, there are two types of production functions. They are as follows. 1. Short Run Production Function In this case, the producer will keep all fixed factors as constant and change only a few variable factor inputs. In the short run, we come across two kinds of production functions 1. Quantities of all inputs both fixed and variable will be kept constant and only one variable input will be varied. For example, Law of Variable Proportions. 2. Quantities of all factor inputs are kept constant and only two variable factor inputs are varied. For example, IsoQuants and Iso Cost curves. 2. Long Run Production Function In this case, the producer will vary the quantities of all factor inputs, both fixed as well as variable in the same proportion. For Example, The laws of returns to scale. Each firm has its own production function which is determined by the state of technology, managerial ability, organizational skills etc of a firm. If there are any improvements in them, the old production function is disturbed and a new one takes its place. It may be in the following manner: 1. The quantity of inputs may be reduced while the quantity of output may remain same. 2. The quantity of output may increase while the quantity of inputs may remain same. 3. The quantity of output may increase and quantity of inputs may decrease.
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5.2.1 Uses Of Production Function
Though production function may appear as highly abstract and unrealistic, in reality, it is both logical and useful. It is of immense utility to the managers and executives in the decision making process at the firm level. There are several possible combinations of inputs and decision makers have to choose the most appropriate among them. The following are some of the important uses of production function. 1. It can be used to calculate or work out the least cost input combination for a given output or the maximum outputinput combination for a given cost. 2. It is useful in working out an optimum, and economic combination of inputs for getting a certain level of output. The utility of employing a unit of variable factor input in the production process can be better judged with the help of production function. Additional employment of a variable factor input is desirable only when the marginal revenue productivity of that variable factor input is greater than or equal to cost of employing it in an organization. 3. Production function also helps in making long run decisions. If returns to scale are increasing, it is wise to employ more factor units and increase production. If returns to scale are diminishing, it is unwise to employ more factor inputs & increase production. Managers will be indifferent whether to increase or decrease production, if production is subject to constant returns to scale. Thus, production function helps both in the short run and long run decision making process. 5.2.2 Production Function With One Variable Input Case THE LAW OF VARIABLE PROPORTIONS This law is one of the most fundamental laws of production. It gives us one of the key insights to the working out of the most ideal combination of factor inputs. All factor inputs are not available in plenty. Hence, in order to expand the output, scarce factors must be kept constant and variable factors are to increased in greater quantities. Additional units of a variable factor on the fixed factors will certainly mean a variation in output. The law of variable proportions or the law of non proportional output will explain how variation in one factor input give place for variations in outputs. The law can be stated as the following. As the quantity of different units of only one factor input is increased to a given quantity of fixed factors, beyond a particular point, the marginal, average and total output eventually decline
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¨ Techniques of production remain constant. ¨ There are possibilities for varying the proportion of factor inputs. An increase in the quantity of a variable factor added to fixed factors. Only one variable factor unit is to be varied while all other factors should be kept constant. first the marginal and then the average product of that factor will diminish”1. ¨ The law will hold good only for a short and a given period. after a point. Sikkim Manipal University 93 . given technical conditions. at the end results in a less than proportionate increase in the amount of product. ASSUMPTIONS OF THE LAW 1.Production Analysis unit 5 The law of variable proportions is the new name for the famous “Law of Diminishing Returns” of classical economists. This law is stated by various economists in the following manner According to Prof. ¨ Different units of a variable factor are homogeneous. “As the proportion of one factor in a combination of factors is increased. Benham. The same idea has been expressed by Prof.Marshall in the following words.
Units of Variable inputs (Labor) 0 1 2 3 4 5 6 7 8 9 10 TP in units 0 10 24 39 52 60 66 70 72 72 70 AP in units 0 10 12 13 13 12 11 10 9 8 7 MP in units 0 10 14 15 13 8 6 4 2 0 2 I Stage II Stage III Stage Total Product or Output : (TP) It is the output derived from all factors units. It is also a sum of marginal output. Marginal Product or Output: (MP) It is the output derived from the employment of an additional unit of variable factor unit Sikkim Manipal University 94 .Production Analysis unit 5 ILLUSTRATION A hypothetical production schedule is worked out to explain the operation of the law. Average Product or Output: (AP). It can be obtained by dividing total output by the number of variable factors employed. Variable factor = labor. Fixed factors = 1 Acre of land + Rs 500000 capital. both fixed & variable employed by the producer.
2. 1. MP increases in the beginning. From the diagram it is clear that there are III stages. & MP. AP will also have the same tendencies as the MP. Sikkim Manipal University 95 . Total output goes on increasing as long as MP is positive.Production Analysis unit 5 Trends in output From the table. Diagrammatic Representation 80 E 70 60 Level of Output 50 40 30 20 10 0 10 1 2 3 4 5 6 7 8 9 10 TP P Series1 Series2 Series3 Stage 1 Stage 2 Stage 3 No. we measure TP. After the point P. The Law Of Increasing Returns The total output increases at an increasing rate (More than proportionately) up to the point P because corresponding to this point P the MP is rising and reaches its highest point. AP. 3. of Units of variable inputs In the above diagram along with OX axis. we measure the amount of variable factors employed and along OY axis. MP decline and as such TP increases gradually. AP & MP. reaches the highest point and diminishes at the end. Stage Number I. It is the highest when MP is zero and TP declines when MP becomes negative. one can observe the following tendencies in the TP. In the beginning MP will be higher than AP but at the end AP will be higher than MP.
Up to certain point substitution is beneficial. Sikkim Manipal University 96 . The I stage is called as the law of increasing returns on account of the following reasons. Diminishing returns arise due to the following reasons: 1. output declines. the T. 2. Imperfect substitutability of factor inputs is another cause. 4. When the producer increases the quantity of variable factor. The II stage comes to an end at the point where TP is the highest at the point E and MP is zero at the point B. When the producer increases the quantity of variable factor. It is only in this stage. 2. Stage Number II The Law Of Diminishing Returns In this case as the quantity of variable inputs is increased to a given quantity of fixed factors.P increases at a diminishing rate since both AP & MP are declining but they are positive. Hence. It is known as the stage of “Diminishing Returns” because both the AP & MP of the variable factor continuously fall during this stage. The proportion of fixed factors is greater than the quantity of variable factors. of the “Indivisible Factors” 3. the fixed factors cannot be compensated by the variable factor. both AP & MP decline. Hence. 3. As more units of the variable factor is employed. The proportion of variable factors are greater than the quantity of fixed factors. Total output diminishes because there is a limit to the full utilization of indivisible factors and introduction of specialization. Diseconomies of scale will operate beyond the stage of optimum production. the firm is maximizing its total output. intensive and effective utilization of fixed factors become possible leading to higher output.Production Analysis unit 5 The first stage comes to an end at the point where MP curve cuts the AP curve when the AP is maximum at N. output increases due to the complete utilization. output increases less than proportionately. Once optimum point is reached. 1. Diminishing returns are bound to appear as long as one or more factors are fixed and cannot be substituted by the others. the efficiency of variable factors will go up because it creates more opportunity for the introduction of division of labor and specialization resulting in higher output. In this stage.
the producer can postpone the occurrence of diminishing returns. Hence. the III stage is a theoretical possibility because no producer would like to come to this stage. It is clear that in the above example. a producer has to select the most economical combination out of them. as the quantity of variable input is increased to a given quantity of fixed factors. output declines. 5. All the 3 stages together constitute the law of variable proportions. the most ideal or optimum combination of factor units = 1 Acre of land+ Rs. The II stage represents the range of rational production decision. Since the second stage is the most important. 5000 00 capital and 9 laborers. Generally. Hence.3 Production Function With Two Variable Inputs ISOQUANTS AND ISO COSTS The prime concern of a firm is to workout the cheapest factor combinations to produce a given quantity of output. There are a large number of alternative combinations of factor inputs which can produce a given quantity of output for a given amount of investment. The negative returns are the result of excessive quantity of variable factors to a constant quantity of fixed factors. It is useful to a businessman in the short run production planning at the microlevel. AP continues to diminish and MP becomes negative. The law gives guidance that by making continuous improvements in science and technology. TP starts diminishing. PRACTICAL application of the law 1.2. In this case. the producer will select the II stage (which is described as the most economic region) where he can maximize the output. 2. During this stage. The stage I & III is described as NONEconomic Region or Uneconomic Region. The proverb “Too many cooks spoil the broth” and “ Too much is too bad” aptly applies to this stage. It helps a producer to work out the most ideal combination of factor inputs or the least cost combination of factor inputs.Production Analysis unit 5 The III Stage The Stage Of Negative Returns. The producer being rational will not select either the stage I (because there is opportunity for him to increase output by employing more units of variable factor) or the III stage (because the MP is negative). in practice we normally refer this law as the law of Diminishing Returns. 3. Hence. output becomes negative. Isoproduct curve is a technique developed in recent Sikkim Manipal University 97 .
Hence. Iso – Quant is also called as Equal Product Curve or Product Indifference Curve or Constant Product Curve. the producer becomes indifferent with respect to any one of the combinations. the producer is indifferent with respect to any one of the combinations mentioned above. If there are different Iso–Quant curves. Hence.” Each Iso – Quant curve represents only one particular level of output. Any point on an Iso–Quant curve represents same level of output.Production Analysis unit 5 years to show the equilibrium of a producer with two variable factor inputs. It is a parallel concept to the indifference curve in the theory of consumption.e. all the five factor combinations will produce the equal level of output.100 units. An Iso – product curve represents all the possible combinations of two factor inputs which are capable of producing the same level of output. Since each point indicates equal level of output. Sikkim Manipal University 98 . they represent different levels of output. It may be defined as – “ a curve which shows the different combinations of the two inputs producing the same level of output . MEANING AND DEFINITIONS The term “Iso –Quant” has been derived from ‘Iso’ meaning equal and ‘Quant’ meaning quantity. i. EQUAL PRODUCT COMBINATION Combinations Factor X (Labor) Factor Y Capital 1 2 3 4 5 Total Output in units A B C D E 12 8 5 3 2 100 100 100 100 100 In the above schedule.
Production Analysis unit 5 Graphic Representation Y 12 ·A Factor X 8 5 3 2 0 ·B ·C ·D ·E IQ X 1 2 3 4 5 Factor Y In the diagram. absolute measurement of output is possible. Hence. if we join points ABCDE (which represents different combinations of factor x and y) we get an Isoquant curve IQ. In other words. Sikkim Manipal University 99 . It is to be noted that an IsoProduct Curve shows the exact physical units of output that can be produced by alternative combinations of two factor inputs. This curve represents 100 units of output that may be produced by employing any one of the combinations of two factor inputs mentioned above. a number of Iso Quants representing different amount of out put are known as Isoquant map. Iso – Quant Map A catalogue of different combinations of inputs with different levels of output can be indicated in a graph which is called as equal product map or Isoquant map.
Production Analysis Y unit 5 Factor X Capital 3000 2000 1000 IQ1 0 Factor Y Labor IQ3 IQ2 X Marginal Rate of Technical Substitution (MRTS) It may be defined as the rate at which a factor of production can be substituted for another at the margin without affecting any change in the quantity of output. Sikkim Manipal University 100 . we can observe that as the quantity of factor Y is increased relative to the quantity of X. quantity of output remaining the same. MRTS of X for Y is the number of units of factor Y that can be replaced by one unit of factor X quantity of output remaining the same. This is known as the law of Diminishing Marginal Rate of Technical Substitution (DMRTS). in this case MRTS of Y for X is 4:1 Generally speaking. For example.2:1 1:1 A B C D E 12 8 5 3 2 In the above example. Hence. we can notice that in the second combination the producer is substituting 4 units of X for 1 unit of Y. the number of units of X that will be required to be replaced by one unit of factor Y will diminish. Combinations Factor X Factor Y 1 2 3 4 5 MRTS of x for y Nil 4:1 3:1 . the MRTS will be diminishing. In the above table.
When 30 units of factor X are represented on OY – axis and 60 units of factor Y are represented on OX axis. It indicates the different combinations of the two inputs which the firm can purchase at given prices with a given outlay. 3. This line represents the different combinations of factor X and Y that can be purchased with Rs. Always one IsoQuant curve need not be parallel to other. An Isoproduct curve lying to the right represents higher output and viceversa. It shows two things (a) prices of two inputs (b) total outlay of the firm. 3. If we join these two points A and B. If the price of X per unit Rs. It will not touch either X or Y – axis.Production Analysis unit 5 Properties of Iso Quants. 5.00 he can purchase 30 units of X. 6. No two Isoproduct curves intersect each other. then we get the IsoCost line AB. ISOCOST LINE OR CURVE It is a parallel concept to the budget or price line of the consumer.00 Y A 3000=00 30 Units of Factor X 0 X B 60 Units of Factor Y Sikkim Manipal University 101 .000 to purchase factor X and Y. An IsoQuant curve slope downwards from left to right. 00 then he can purchase 60 units of Y. Each Isocost line will show various combinations of two factors which can be purchased with a given amount of money at the given price of each input. 100 . Generally an IsoQuant curve is convex to the origin. 3. 2. we get two points A & B. 50. Similarly if the price of factor Y is Rs. We can draw the Isocost line on the basis of an imaginary example. 4.000. Let us suppose that a producer wants to spend Rs. 1.
Profits can be maximized when he is producing maximum output with minimum production cost. 4. 00 to Rs. 3. On the contrary.00000. 3. Isocost line shows the total outlay of the producer and the prices of factors of production. 2. the price of any one of them changes there would be a corresponding change in the slope and position of Isocost line. 2. In order to explain producer’s equilibrium. if his outlay decreases to Rs. On the other hand.000/ A Rs.000/ Rs. Isoproduct curve represent different alternative possible combinations of two factor inputs with the help of which a given level of output can be produced. The slope of the Isocost line represents the ratio of the price of a unit of factor X to the price of a unit of factor Y. there will be a backward shift in the position of Isocost line.000. Y Sikkim Manipal University 102 . Hence. Maximum output with minimum cost is possible only when he reaches the position of equilibrium.Production Analysis unit 5 The IsoCost line will shift to the right if the producer increase his outlay from Rs.000/ 0 B Q N Factor y X PRODUCERS EQUILIBRIUM (Optimum factor combination or least cost combination) The optimal combination of factor inputs may help in either minimizing cost for a given level of output or maximizing output with a given amount of investment expenditure. 4. The position of equilibrium is indicated at the point where Iso Quant curve is tangential to IsoCost line. the producer selects the least cost combination of the factor inputs. The intention of the producer is to maximize his profits.000 00. The following diagram explains how the producer reaches the position of equilibrium. we have to integrate Isoquant curve with that of Isocost line. Y M Factory X P Rs. In case.
An increase in scale means that all factor inputs are increased in the same proportion. all the necessary factor inputs are increased or decreased to the same extent so that what ever the scale of production. he cannot move to the left side of E. 5000.2. Thus. 5. (assuming Rs. He will not reach the position of equilibrium either at the point E1 and E2 because they are on a higher Isocost line. Rs. i. the proportion among the factors remains the same.100 x 25 units of 2500 00 and Rs. In returns to scale. Similarly. we study the change in output when all factor inputs are changed or made available in required quantity. 5.10000 and that of Y is Rs.. 50 x 50 units of Y = 2500 00.4 Long Run Production Function [Change In All Factor Inputs In The Same Proportion] LAWS OF RETURNS TO SCALE The concept of returns to scale is a long run phenomenon. Sikkim Manipal University 103 . At this point.e.500 each is spent on X and Y) The price of one unit of factor X is Rs. MRTS between the two points is equal to the ratio between the prices of the inputs. 500 units by employing 25 units of factors X and 50 units of factor Y. the point at which the IsoQuant is tangent to the IsoCost line represents the minimum cost or optimum factor combination for producing a given level of output. because they are on a lower IsoCost line and he will not be able to produce 500 units of output by any combinations which lie to the left of E.000 the producer will be producing the highest output. In this case. 2. With a given total out lay of Rs.Production Analysis unit 5 Y M E 1 A 25 Units R Factor “X” 0 E · Point of equilibrium IQ X E 2 S B N 50 Units Factor “Y” It is quite clear from the diagram that the producer will reach the position of equilibrium at the point E where the Isoquant curve IQ and Isocost line AB is tangent to each other.
Sl No.Production Analysis unit 5 Three Phases of Returns to Scale Generally speaking. it is possible that all factor inputs can be changed in the same proportion and the output is steadied when the input is doubled or tripled or increased fivefold or tenfold. An ordinary person may think that when the quantity of inputs is increased 10 times. the scale of output or returns to scale may be either more than equal. The output increases more than proportionately when the producer is employing 4 acres of land and 9 units of Sikkim Manipal University 104 .e. Thus. then the returns to scale are said to be constant; when the output increases less than proportionately. then the returns to scale are said to be diminishing. But it may or may not happen as expected. we may get increasing returns. by 1 acre of land and 2 units of labor through out in our example. Scale Total Product in Units Marginal Product in units 5 7 9 11 11 11 9 7 1 2 3 4 5 6 7 8 1 Acre of land + 3 labor 2 Acre of land + 5 labor 3 Acre of land + 7 labor 4 Acre of land + 9 labor 5 Acre of land + 11 labor 6 Acre of land + 13labor 7 Acre of land + 15 labor 8 Acre of land + 17 labor 5 12 21 32 43 54 63 70 It is clear from the table that the quantity of land and labor (Scale) is increasing in the same proportion. we study the behavior pattern of output when all factor inputs are increased in the same proportion under returns to scale. Many economists have questioned the validity of returns to scale on the ground that all factor inputs cannot be increased in the same proportion and the proportion between the factor inputs cannot be kept uniform. It may be noted that when the quantity of inputs are increased in the same proportion. But in some cases. equal or less than equal. when the scale of output is increased. When the quantity of all factor inputs are increased in a given proportion and output increases more than proportionately. i. output will also go up by10 times. constant returns or diminishing returns. then the returns to scale are said to be increasing; when the output increases in the same proportion.
output increases more than proportionately. it is clear that the marginal returns curve slope upwards from A to B. Thus. Output increases in the same proportion when the quantity of land is 5 acres and 11units of labor and 6 acres of land and 13 units of labor. In the later stages. when he employs 7 & 8 acres of land and 15 & 17 units of labor. For Sikkim Manipal University 105 . output increases less than proportionately. The curve is horizontal from B to C indicating constant returns to scale and from C to D. Diagrammatic representation In the diagram. the curve slope downwards from left to right indicating the operation of diminishing returns to scale.Production Analysis unit 5 labor. indicating increasing returns to scale. one can clearly understand the operation of the three phases of the laws of returns to scale with the help of the table. Y II Stage B 10 ¾ C Rtns C Marginal Returns 8 ¾ I Stage III Stage I Rtns 6 ¾ D Rtns D 4 ¾ 2 ¾ A | 1 | 2 | 3 | 4 | 5 6 | | | X ` 7 8 Factor units Employed INCREASING RETURNS TO SCALE: Increasing returns to scale is said to operate when the producer is increasing the quantity of all factors [scale] in a given proportion.
a producer is employing lesser quantities of inputs and his production cost is declining. It implies that in order to get an increase in output by another 100 units. an equal product map has been drawn with the assumption that only two factors X and Y are required. The distance between each Iso Quant curve is progressively diminishing.OX axis and factor Y is represented along OY axis. Thus. In order to explain the operation of this law.Production Analysis unit 5 example. It is very clear that the increase in the quantities of factor X and Y [scale] is small as we go up the scale and the output is larger. and output increases by 15%. the law of increasing returns to scale is operating Factor‘Y’ Capital) Scale Line P ·F ·E ·D ·C ·B ·A 600 500 400 300 200 100 0 X Factor ‘X’ (Labour) Causes for Increasing Returns to Scale Increasing returns to scale operate in a firm on account of several reasons. The scale line OP represent different quantities of inputs where the proportion between factor X and factor Y is remains constant. Factor X is represented along . Some of the most important ones are as follows Sikkim Manipal University 106 . The scale line OP passing through origin is called as the “Expansion path”. the return increases from 100 units of output to 200 units. when the quantity of all inputs are increased by 10%. In the diagram. then we say that increasing returns to scale is operating. The scale line OP is a straight line passing through the origin on the Iso Quant map indicating the increase in scale as we move upward. Any line passing through the origin will indicate the path of expansion or increase in scale with definite proportion between the two factors. When the scale is increased from A to B.
it becomes possible to enjoy several other kinds of economies of scale like overhead. it is possible to introduce the principle of division of labor and specialization. Wider scope for the use of latest tools. output also increases in the same proportion. output also increases in the same proportion. 3. It shows that with constant returns to scale. As the size of the plant increases. It is important to note that economies of scale outweigh diseconomies of scale in case of increasing returns to scale.In the diagram. and output also increases exactly by 10%. financial. 5. which is responsible for cost reduction. equipments. techniques etc to increase production and reduce cost per unit. Sikkim Manipal University 107 . As output increases. 2. It indicates that as the producer increases the quantity of both factor X and Y in a given proportion. Along the scale line OP. As output increases. CONSTANT RETURNS TO SCALE Constant returns to scale is operating when all factor inputs [scale] are increased in a given proportion. what ever may be the level of output. marketing and riskbearing economies etc. it is clear that the successive Iso Quant curves are equi distant from each other.Production Analysis unit 5 1. machineries. more output can be obtained at lower cost. When the quantity of all inputs is increased by 10%. 4. Largescale production leads to full and complete utilization of indivisible factor inputs leading to further reduction in production cost. Economists also describe Constant returns to scale as the Linear homogeneous Production function. then we say that constant returns to scale are operating. effective supervision and scientific management of the firm etc would help in reducing cost of operations. there will be one input proportion which does not change.
the various internal and external economies of scale are neutralized by internal and external diseconomies. it is clear that the distance Between each successive Iso Quant curve Is progressively increasing along the scale line OP it indicates that as the producer is increasing the quantity of both factor X and Y.Production Analysis Y unit 5 P Factor ‘Y’ (Capital) Scale Line ·E ·D ·C ·B ·A 500 units 400 units 300 units 200 units 100 units 0 X Factor ‘X’ (Labour) Causes for Constant Returns to Scale In case of constant returns to scale. in a given proportion. output increases less than proportionately. and output increases by 5%. DIMINISHING RETURNS TO SCALE Diminishing returns to scale is operating when output increases less than proportionately when compared the quantity of inputs used in the production process. Sikkim Manipal University 108 . For example. Thus. then we say that diminishing returns to scale is operating. Thus. the law of Diminishing returns to scale is operating. when the quantity of all inputs are increased by 10%. constant returns to scale will operate. In the diagram. when both internal and external economies and diseconomies are exactly balanced with each other.
Inefficient and mismanagement due to over growth and expansion of the firm. The result is the operation of diminishing returns to scale. maintain the same level or decrease it depending on the demand for the product. The concept of Returns to Scale helps a producer to workout the most desirable Combination of factor inputs so as to maximize his output and minimize his production cost. to increase his production. Sikkim Manipal University 109 . 3. diseconomies outweigh economies of scale. It also helps him. 5. Thus. 2. Emergence of difficulties in coordination and control. Difficulty in effective and better supervision. in this case. 4.Production Analysis Y Scale Line unit 5 P Factor ‘Y’ (Capital) ·F ·E ·D ·B ·A ·C 600 units 500 units 400 units 300 units 200 units 100 units X 0 Factor ‘X’ (Labour) Causes for Diminishing Returns to Scale Diminishing Returns to Scale operate due to the following reasons 1. Productivity and efficiency declines unavoidably after a point. Delays in management decisions.
5 Economies Of Scale The study of economies of scale is associated with large scale production. 2.2. They arise due to increased division of labor or specialization and complete utilization of indivisible factor inputs. Prof. 6. 8. They can be effectively controlled by the management of a firm. 5. Marshall these economies are of two types. They help in reducing production cost and establishing an optimum size of a firm. They arise due to improvements in internal factors. they help a lot and go a long way in the development and growth of a firm. I Internal Economies or Real Economies Internal Economies are those economies which arise because of the actions of an individual firm to economize its cost. “The advantages or benefits that accrue to a firm as a result of increase in its scale of production are called ‘Economies of scale’. They arise “with in” or “inside” a firm. Today there is a general tendency to organize production on a large scale basis. They arise due to specific efforts of one firm. The following are some of the important aspects of internal economies. They are dependent on the size of the firm. 4. 3. Sikkim Manipal University 110 . 7. Large scale production is beneficial and economical in nature. They are called as “Business Secrets “of a firm. viz Internal Economies and External Economics Now we shall study both of them in detail. Thus. They have close relationship with the size of the firm. Mass production of standardized goods has become the order of the day. They are particular to a firm and enjoyed by only one firm. They are gain to a firm. They arise due to increase in the scale of production.Production Analysis unit 5 5. They influence the average cost over different ranges of output. They arise on account of an increase in the scale of output of a firm and cannot be achieved unless output increases. According to Prof. 1. Cairncross points out that internal economies are open to a single factory or a single firm independently of the actions of other firms.
Economies of increased dimension: It is found that a firm enjoys the reduction in cost when it increases its dimension. Sikkim Manipal University 111 . 1. cultivating the land with modern tractors instead of using age old wooden ploughs and bullock carts. use of computers instead of human labor etc. and bagasse of sugar factory can be used for the production of paper. in diary farming. Technical Economies These economies arise on account of technological improvements and its practical application in the field of business. a large firm can make use of its wastes and byproducts in the most economical manner by producing other products. For example.Production Analysis unit 5 Kinds of Internal Economies. an increase in dimension of a firm will reduce the cost of production. e. Similarly. Economies arising out of research and by products: A firm can invest adequate funds for research and the benefits of research and its costs can be shared by all other firms. cane pulp. For example. Thus. nursing homes etc. Inventory management is a part of better materials management. Also it is possible that different firms through mutual agreement may decide to work together and derive the benefits of linked processes. it can ask the seller of the inputs to supply them just before the commencement of work in the production department each day. a. for example. d. The rationale of the JustinTime technique is that instead of having huge stocks worth of lakhs and crores of rupees. Economies of superior techniques: These economies are the result of the application of the most modern techniques of production. A large firm avoids wastage of time and economizes its expenditure. it becomes possible to employ bigger and better types of machinery. c. printing press. For example. Just InTime or zero level inventory techniques. operation of a double decker instead of two separate buses. b. The latest and improved techniques give place for specialized production. varnish distilleries etc. Economies of linked process: It is quite possible that a firm may not have various processes of production with in its own premises. Economies of techniques or technical economies are further subdivided into five heads. For example. A big firm can save a lot of money by adopting latest inventory management techniques. molasses. It is bound to be cost reducing in nature. Inventory Economies. When the size of the firm grows.
and scientific management of a firm. A large firm can float debentures and issue shares and get subscribed by the general public. machine suppliers etc. capital market. The firm can have a separate selling organization. efficient. it can get quantity discounts and rebates.. Delegation of details The general manager of a firm cannot look after the working of all processes of production. Another advantage will be that the raw material suppliers. A large firm can buy raw materials and other inputs in bulk at concessional rates. and other private financial institutions at concessional interest rates. Financial Economies They arise because of the advantages secured by a firm in mobilizing huge financial resources. Managerial Economies. It can follow an aggressive sales promotion policy to influence the decisions of the consumers 4. It is possible to secure economies of large scale production by dividing the work of management into several separate departments. In order to keep an eye on each production process he has to delegate some of his powers or functions to trained or specialized personnel and thus relieve himself for co ordination. 3. A firm can reduce its selling costs also. Functional Specialization. This will enable him to bring about improvements in production process and in bringing down the cost of production. planning and executing the plans. Marketing or Commercial economies: These economies will arise on account of buying and selling goods on large scale basis at favorable terms. b.Production Analysis unit 5 2. because they are likely to get bulk Sikkim Manipal University 112 . a. It is also possible to have large overdrafts from banks. This would lead to higher efficiency and reduction in the cost of production. A large firm can have its own sales agency and channel. It can borrow from banks at relatively cheaper rates. This will ensure better and more efficient productive management with scientific business administration. They arise because of better. Such economies arise in two different ways. are willing to supply material and components at comparatively low rates. name and fame can mobilize huge funds from money market. A large firm on account of its reputation. Each department is placed under an expert and the rest of the work is left into the hands of specialists. marketing department manned by experts who are well versed in the art of pushing the products in the market. In this way economies may be secured in the purchase of different inputs. As the bargaining capacity of a big firm is much greater than that of small firms.
9. bookkeeping. highly organized and cheap transport and storage facilities and their complete utilization. a firm can also have its own storage facilities which reduce cost of operations. Thus. most of the costs become controllable costs which help an enterprise to reduce cost of production. the survival of the firm may become. sports rooms etc. it can employ a large number of highly talented persons and get the benefits of specialization and division of labor. a big firm has an edge over small firms in securing sufficient funds more easily and cheaply. etc. trained. Over Head Economies These economies will arise on account of large scale operations.Production Analysis unit 5 orders. conserve the scarce resources. 7. 6. Riskbearing or survival economies These economies will arise as a result of avoiding or minimizing several kinds of risks and uncertainties in a business. It can provide better working conditions promotional opportunities. and create facilities like subsidized canteen. Similarly. These economies will arise as a result of employing skilled. rest rooms. Hence. It can also impart training to existing labor force in order to raise skills. cost per unit will be low if production is organized on large scale. economize the expenditure and save labor time. difficult. Unless these risks are effectively tackled. All these measures will definitely raise the average productivity of a worker and reduce the cost per unit output. As a firm expands. Hence many Sikkim Manipal University 113 . New schemes may be chalked out to speed up the work. 8. Economies of Vertical integration A firm can also reap this benefit when it succeeds in integrating a number of stages of production. are more or less the same whether production is carried on small or large scale. efficiency and productivity of workers. A manufacturing unit has to face a number of risks in the business. Because of vertical integration. 5 Labor Economies. crèches for infants. qualified and highly experienced persons by offering higher wages and salaries. Transport and Storage Economies They arise on account of the provision of better. recreations. administration. A large company can have its own fleet of vehicles or means of transport which are more economical than hired ones. It secures the advantages that the flow of goods through various stages in production processes is more readily controlled. The expenses on establishment.
the riskbearing capacity of a big firm will be much greater than that of a small firm.Production Analysis unit 5 steps are taken by a firm to eliminate or to avoid or to minimize various kinds of risks. II. 1. If consumers in one market desert a product. Stonier & Hague points out that external economies are those economies in production which depend on increase in the output of the whole industry rather than increase in the output of the individual firm The following are some of the important aspect of external economies. They are general. ¨ Diversification of market: Instead of selling the goods in only one market. Risk is avoided when few firms amalgamate or join together or when competition between different firms is either eliminated or reduced to the minimum or expanding the size of the firm. 2. 3. a firm can buy from several sources. External Economies or Pecuniary Economies External economies are those economies which accrue to the firms as a result of the expansion in the output of whole industry and they are not dependent on the output level of individual firms. If one person fails to supply. A large firm secures riskspreading advantages in either of the four ways or through all of them. a firm has to sell its products in different markets. ¨ Diversification of the process of manufacture: Instead adopting only one process of production to manufacture a commodity. They arise due to collective efforts of an industry. 5. 4. it is better to use different processes or methods to produce the same commodity so as to avoid the loss arising out of the failure of any one process. a firm has to produce multiple products If there is loss in one item it can be made good in other items. it is better to purchase them from different sources. These economies or gains will arise on account of the over all growth of an industry or a region or a particular area. expansion & growth of an industry or a Sikkim Manipal University 114 . They arise due to overall development. Prof. They arise due to improvement in external factors. They arise ‘outside’ the firm. it can cover the losses in other markets. Generally speaking. They arise due to benefit of localization and specialized progress in the industry or region. ¨ Diversification of output Instead of producing only one particular variety. ¨ Diversification of source of supply: Instead of buying raw materials and other inputs from only one source. common & enjoyed by all firms.
information papers etc have helped a lot in the dissemination of quick information. Economies of concentration or Agglomeration They arise because in a particular area a very large number of firms which produce the same commodity are established. to have discussions with others. Another form of benefit that arises due to localization of industry is economies of information. trained educated and skilled labor. raw materials financial assistance through private and public institutions at low interest rates. Economies of Information These economies will arise as a result of getting quick. 2. it helps in reducing the cost of operation of a firm. publication of journals. This will help in developing contacts between different firms. workshops. expansion in inter net facilities. water. Revolution in the field of information technology. services of specialists or outside experts. transport and communication. it becomes possible for them to exchange their views frequently. magazines. 8. Similarly. Thus. 3. training camps. Statistical. technical and other market information becomes more readily available to all firms. mobile phones. The following benefits of localization of industry is enjoyed by all the firms provision of better and cheap labor at low or reasonable rates. etc has helped in the free flow of latest information from all parts of the globe in a very short span of time. They are called as “open secrets “of a firm. emails. When an industry grows beyond a Sikkim Manipal University 115 . maintenance and service shops. better use of by products and other such benefits. When interfirm relationship strengthens. power. seminars. it helps a lot to economize the expenditure of a single firm. 6. symposiums. Since a large number of firms are located in a region. 7. They are dependent on the size of industry. They are beyond the control of management of a firm. Economies of Disintegration These economies will arise as a result of dividing one big unit in to different small units for the sake of convenience of management and administration. latest and up to date information from various sources. demonstrations on topics of mutual interest. Kinds of External Economies 1.Production Analysis unit 5 region. marketing facilities. video conferences. to organize lectures. In other words. this is an advantage which arises from what is called ‘Localization of Industry’. benefits of common repairs.
in order to encourage the development of private industries have come up with several kinds of assistance. For example. some firms may specialize in manufacturing threads. one should not cross the limit. subsidies. fertility of the soil. The following are some of the main diseconomies of scale Sikkim Manipal University 116 . in that case.2. Economies of Physical Factors These economies will arise due to the availability of favorable physical factors and environment. A big industry is in a better position to provide welfare facilities to the workers. 5. economies of scale will be converted in to diseconomies of scale. As the size of an industry expands. physical environment in a particular place may help all firms to enjoy certain physical benefits. It may also establish health care units. Economies of Government Action These economies will arise as a result of active support and assistance given by the government to stimulate production in the private sector units. weather conditions. etc. a few others in printing. This will certainly enhance the efficiency in the working of a firm and cut down unit costs considerably. It may get land at concessional rates and procure special facilities from the local governments for setting up housing colonies for the workers. 5.6 Diseconomies Of Scale When a firm expands beyond the optimum limit. For example. training centers. In recent years the government. 4. positive physical environment may to reduce the costs of all firms working in the industry. On account of diseconomies of scale. It is quite clear from the above detailed description that both internal and external economies arise on account of large scale production and they are benefits to a firm and cost reducing in nature.Production Analysis unit 5 limit. it becomes necessary to split it in to small units. development rebates financial assistance at low interest rates. Economies of Welfare These economies will arise on account of various welfare programs under taken by an industry to help its own staff. in cotton textiles industry. 4. Over growth becomes a burden. more output is obtained at higher cost of production. All these measures would help in raising the overall efficiency and productivity of workers. and some others in dyeing and coloring etc. taxholidays. Hence. It may grant concessions to its workers. It is granting taxconcessions. New subsidiary units may grow up to serve the needs of the main industry. Climate. taxexemptions. computer centers and educational institutions of all types.
Supply of factor inputs become inelastic leading to high prices. Thus. Workers may demand higher wages and salaries. per unit cost will certainly go up. power. All of them may contribute for higher operation costs. Unplanned excess production may lead to mismatch between demand and supply of goods leading to fall in prices. they become negative. transport and communications etc leading to higher production and operational costs. 2. environmental pollution. it is bound to experience diseconomies of scale. coordination of factors of production leading to all kinds of wastages. Consequently. Sales do not go up correspondingly. Technical diseconomies When output is carried beyond the plant capacity. 6. a new computer firm can commence its operations Sikkim Manipal University 117 . The level of inventory goes up. higher interest rates are to be paid for additional funds. there should be proper check on the growth and expansion of a firm. it may lead to congestion. Beyond the optimum limit. A firm may start a new unit in between two big railway stations or near the air port or near the national high ways or a port so that it can enjoy all the infrastructure benefits. Marketing diseconomies. If output expends beyond a limit. An unwieldy firm may become impersonal. Hence. Contact between labor and management may disappear. raw materials. scarcity of factor inputs like. . Labor unions may not cooperate with the management. 5. sales may decline leading to fall in revenue and profits. it is very clear that a firm can enjoy benefits of large scale production only up to a limit. There is a limit for division of labor and specialization. 4. 3. control management. operation costs would go up. Diseconomies of risk and uncertainty bearing. water. fuel. indiscipline and rise in production and operating costs.7 Internalisation Of External Economies It implies that a firm will convert certain external benefits created by the government or the entire society to its own favor with out making any additional investments.2. When several business units are concentrated in only place or locality. Beyond a point. investment increases.Production Analysis unit 5 1. Labor diseconomies. Business risks appear in all fields of activities. the required amount of fiancée may not be available to a firm. Financial diseconomies. Industrial disputes may arise. bonus and other such benefits etc. II External diseconomies. Similarly.. Stocks may pile up. Hence. As there is over growth. 5. Managerial diseconomies Excess growth leads to loss of effective supervision.
a particular firm on account of its regular operations will pass on certain costs on the entire society. 5. dirt and filth either to open air or rivers leading to environmental pollution. we also come across another type of benefits in recent years. Such type of efforts is to be encouraged by the government. For example. In this case. the government is forced to spend more money to clean river water or prevent environmental pollution. They are popularly known as economies of scope. Hence. This is a clear case of externalized internal diseconomies. It is to be avoided at all costs. they are also called as privatization of public benefits. Apart from these two types of benefits. C [Q1] + C [ Q2] C [ Q1and Q2] SC = C [Q1 and Q2] Sikkim Manipal University 118 . 5.8 Externalisation Of Internal Diseconomies In this case. Economies of scope may be defined as those benefits which arise to a firm when it produces more than one product jointly rather than producing two items separately by two different business units. It can be measured with the help of the following equation. production cost per unit declines and more output is obtained at lower cost of production.2. As a result. a firm may throw chemical or industrial wastes. Economies of scope results in saving production costs. Sometimes. joint marketing efforts.9 Economies Of Scope It is a common factor to observe that when a singleproduct firm expands its volume of output. A firm instead of taking certain precautionary measures by spending some amount of money will escape and pass on this burden to the government or the society.2. it would enjoy certain economies of scale. Sometimes they would enjoy certain other external benefits due to the overall improvements in the entire area or city in which operates. the benefits of the joint output of a single firm are greater than the benefits if two products are produced separately by two different firms. Such benefits may arise on account of joint use of production facilities.Production Analysis unit 5 where there is 24 hours supply of electricity. In that case. or use of the same administrative office and staff in an organization. production of one product automatically results in the production of another byproduct leading to a reduction in average cost of production.
Difference between Economies of Scale and Economies of Scope . it is not possible to produce two goods together.00000 10. 2.00000 3. the SC is more than zero. 8000 – 00 and cost of producing 100 units of B is Rs. it is connected with increase or decrease in distribution & marketing. it is associated with supply side changes in output.00000 10.00000 SC = = = 0. It involves buying two different machineries. If the firm produces both products A & B jointly. Economies of scale 1. C Q2 = cost of producing outputQ2 and C [Q1.Production Analysis unit 5 Where SC = Saving Cost.00000] is less than a sum of individual costs [13. 5. in that case.10 Diseconomies Of Scope Diseconomies of scope may be defined as those disadvantages which occur when cost of producing two products jointly are costlier than producing them individually. 8. its total cost would be Rs. In this case. It shows change in output of a single product 3. C Q1 = cost of producing output Q1. it is associated with demand side changes in output Sikkim Manipal University 119 . production costs would certainly go up in this case. Cost of producing 100 units of A is Rs. Hence.00000 – 10.00000 + 5. Q2] = joint cost of producing both outputs. it would be profitable to produce two goods separately than jointly. Hence. For example. 3. 10. with the help of same machinery. Economies of scope 1. It is connected with increase or decrease in scale of production 2.00000].000 00. ILLUSTRATION A firm produces product A & B separately. Thus. the joint cost [10.2.00000. Now one can find out saving cost by substituting the values to the above mentioned formula. it shows a change in output of more than one products.3 In this case. a firm can save 3% cost if it produces both products A & B jointly. 5.
Cost estimates are made in terms of money. Cost is analyzed from the producer’s point of view. Production creates _____ or ___ of value. Internal economic depends on the growth of a ___ and external economics depends on the growth of the ____. The compensation is the cost. 3. When all inputs are increased by 8% and output increases by 13% then its is a case of laws of ____.two items separately by two firms. 1. These factor inputs are to be compensated by the producer for the services in the production of a commodity.3 Cost Of Production Meaning.Production Analysis unit 5 4. 7. An ISO _ quant curve shows combination of the inputs which helps to produce same level of output where as an ISOcost curve shows __ combination of two inputs that can be purchased with a given that can be purchased with a given investment to prices two factor inputs. occupies a prominent place in cost analysis. It indicates savings in cost due to production of more than one product. When marginal product is zero toal product will be _________. Cost calculations are indispensable for management decisions. 2. In short. In the production process. 5. 5. The knowledge of various concepts of costs. a producer employs different factor inputs. costoutput relationship etc. 8. Production function explain ___ or ____ relationship between inputs and outputs. Sikkim Manipal University 120 . 6. it refers total money expenses incurred to produce a particular quantity of output by the producer. Economic of scope refers to the benefits which arise to a firm when it produces more than _______ rather than producing more than ________. It indicates savings in cost owing to increase in volume of output Self Assessment Questions 1 4. The value of inputs required in the production of a commodity determines its cost of output. 4. Cost of production refers to the total money expenses (Both explicit and implicit) incurred by the producer in the process of transforming inputs into outputs. In the short period only ___________ factor inputs are changed.
2 Different Kinds Of Cost Concepts. the knowledge of money cost is of great importance in economics. To decide what sales channel to use. reprising of input factors etc. To decide and determine the very existence of a firm in the production field. 10. To have clarity about the various cost concepts. 11. 7. To determine in advance the cost of business operations. To fix the price of the product. the discomforts. Sikkim Manipal University 121 . choice etc. Money Cost and Real Cost When cost is expressed in terms of money. all kinds of cost estimations and calculations are made in terms of money only. the pains.Production Analysis unit 5 5. It helps the management – 1. To have a clear understanding of alternative plans and the right costs involved in them. 3. . displeasures and inconveniences which various members of the society have to undergo to produce a commodity. To locate weak points in production management to minimize costs. When cost is expressed in terms of physical or mental efforts put in by a person in the making of a product.3.3. 9. It refers to the physical. To regulate the number of firms engaged in production. it is called as money cost It relates to money outlays by a firm on various factor inputs to produce a commodity. Exact measurement of money cost is possible. 2. In a monetary economy. 1. so as to fit the relevant costs into management planning. 5. To find the most profitable rate of operation of the firm. 4. To determine the optimum quantity of output to be produced and supplied. It is a subjective And relative concept and hence exact measurement is not possible.1 Managerial Uses Of Cost Analysis A detailed study of cost analysis is very useful for managerial decisions. sacrifices.Hence. To decide about the method of cost estimation or calculations. To find out decision making costs by reclassifications of elements. the exertions. 8. it is called as real cost. mental or psychological efforts. 12. 6. 5.
fuel and other types of inputs. If the cost of buying a computer is much lower than that of the total wages to be paid to the workers over a period of time. power. Implicit or imputed costs are implied costs.Production Analysis unit 5 2. They are those costs that involve financial expenditures at some time and hence are recorded in the books of accounts. Hence. For example. They do not take the form of cash outlays and as such do not appear in the books of accounts. it is better to employ workers instead of buying a computer. The knowledge of opportunity cost is of great importance to management decision. opportunity cost of anything is the cost of displaced alternatives or costs of sacrificed alternatives. Hence. They are the actual expenses incurred for producing or acquiring a commodity or service by a firm. Opportunity cost represents only sacrificed alternatives. Opportunity cost of a good or service is measured in terms of revenue which could have been earned by employing that good or service in some other alternative uses. Sikkim Manipal University 122 . In other words. the factor inputs owned by the entrepreneur himself like capital can be utilized by himself or can be supplied to others for a contractual sum if he himself does not utilize them in the business. Implicit or Imputed Costs and Explicit Costs Explicit costs are those costs which are in the nature of contractual payments and are paid by an entrepreneur to the factors of production [excluding himself] in the form of rent. interest and profits. absolute costs and acquisition costs. While taking a decision among several alternatives. if the total wage bill is much lower than that of the cost of computer. 3. a manager selects the best one which is more profitable or beneficial by sacrificing other alternatives. They are the earnings of owneremployed resources. They can be exactly calculated and accounted without any difficulty. They can be estimated and calculated exactly and recorded in the books of accounts. It implies that opportunity cost of anything is the alternative that has been foregone. and payments for raw materials etc. wages paid to workers. Actual costs and Opportunity Costs Actual costs are also called as outlay costs. On the other hand. they can never be exactly measured and recorded in the books of accounts. they are also called as alternative costs. expenses on raw materials. It is to be remembered that the total cost is a sum of both implicit and explicit costs. wages. a firm may decide to buy a computer which can do the work of 10 laborers. They help in taking a decision among alternatives. it will be a wise decision. utility expenses. Thus. For example. a firm has to take a number of decisions almost daily. For example.
Past costs are those costs which are spent in the previous periods.It implies additional cost incurred to produce an additional unit of output It has nothing to do with fixed cost and is always associated with variable cost. They are the added costs due to a change in the level or nature of business activity. in the future. They remain constant irrespective of the level of output. variable costs are those costs which directly and proportionately increase or decrease with the level of output produced. cost involved in the setting up of a new sales depot in another city or cost involved in the production of another 100 extra units. 7. Past and future costs. expenses on raw materials. They cannot be attributed to a product. They are also called as supplementary or over head costs. For example. indirect costs are those costs. water bill. They are also called as prime costs or direct costs. Direct costs and indirect costs Direct costs are those costs which can be specifically attributed to a particular product. future costs are those which are to be spent. On the other hand. which are not traceable to any one unit of operation. They are positive even if there is no production. On the other hand. For example. expenses incurred on electricity bill. Fixed costs and variable costs. 6.Production Analysis unit 5 4. Fixed costs are those costs which do not vary with either expansion or contraction in output. telephone bill. wages to workers. On the other hand. Past helps in taking decisions for future. For example. or a process of production. a department. a department or a process. fuel. salary to a divisional manager etc are direct costs. Sikkim Manipal University 123 . 5. Incremental cost on the other hand refers to the costs involved in the production of a batch or group of output. administrative expeneses etc. Marginal and Incremental costs Marginal cost refers to the cost incurred on the production of another or one more unit .
3. Accounting costs are those costs which are already incurred on the production of a particular commodity. Prices of input factors . 1. It involves the application of opportunity costs in decision making. They are the actual costs involved in the making of a commodity. On the other hand. It includes only the acquisition costs. reduction in production costs and resulting in higher output. primitive technology would lead to higher production costs. 5. Efficiency of factors of production and the management Higher productivity and efficiency of factors of production would lead to lower production costs and viceversa. versa. Higher market prices of various factor inputs result in higher cost of production and vice Sikkim Manipal University 124 . On the other hand. 5.Production Analysis unit 5 8. Size of Plant and scale of production Generally speaking big companies with huge plants and machineries organize production on large scale basis and enjoy the economies of scale which reduce the cost per unit. Technology Modern technology leads to optimum utilization of resources. They have enough importance in modern business set up and decision making process.3 Determinants Of Costs Cost behavior is the result of many factors and forces. However. economists have given some factors considering them as general determinants of costs. avoid all kinds of wastages. The following factors deserve our attention in this connection. 4. 3. saving of time. But it is very difficult to determine in general the factors influencing the cost as they widely differ from firm to firm and even industry to industry. 2. economic costs are those costs that are to be incurred by an entrepreneur on various alternative programs. Rate of output: (the degree of utilization of the plant and machinery) Complete and effective utilization of all kinds of plants and equipments would reduce production costs and under utilization of existing plants and equipments would lead to higher production costs. Accounting costs and economic costs.
cost function depends on three important variables. Stability of output Stability in production would lead to optimum utilization of the existing capacity of plants and equipments. However. Thus. 5. Law of returns Increasing returns would reduce cost of production and diminishing returns increase cost.3. The relation between the cost and output is technically described as the “COST FUNCTION”. Generally speaking there are two types of cost functions. cost function becomes higher and vice versa. it will be low as it is possible to make all kinds of adjustments and readjustments in production process. Time period In the short run. the cost function becomes cheaper and viceversa. Types of cost function. 3. many factors influence cost of production of a firm. Cost and output are correlated.Production Analysis unit 5 6.4 CostOutput Relationship: Cost Function. in that case. 2. Cost output relations play an important role in almost all business decisions. 7. It throws light on cost minimization or profit maximization and optimization of output. cost will be relatively high and in the long run. Sikkim Manipal University 125 . The significance of costoutput relationship is so great that in economic analysis the cost function usually refers to the relationship between cost and rate of output alone and we assume that all other independent variables are kept constant. The market prices of inputs If market prices of different factor inputs are high in that case. Period of time Cost function becomes cheaper in the long run and it would be relatively costlier in the short run. It also brings savings of various kinds of hidden costs of interruption and learning leading to higher output and reduction in production costs. 8. 1. 1 Production function If a firm is able to produce higher output with a little quantity of inputs. Mathematically speaking TC = f (Q) where TC = Total cost and Q stands for output produced. Short run cost function.
Long run cost function. Fixed costs Sikkim Manipal University 126 . buildings. we get short run and long run cost curves of the firm. Generally speaking. equipments. plants. Hence. Hence. CostOutput Relation Ship And Cost Curves In The ShortRun. We shall study these two concepts of costs in some detail 1. Thus. shortrun and long run. The costoutput relationship in the short run refers to a particular set of conditions where the scale of operation is limited by the fixed plant and equipment. 5. cost of production will be relatively higher in the shortrun when compared to the long run. On the other hand. They remain unchanged over a period of time. or by having over time work for the existing labor force or by intensive utilization of existing stock of capital assets etc. superior type of labor. Now we shall make a detailed study of cost out put relations both in the shortrun as well as in the long run. in the short period some inputs are fixed in amount and a firm can expand or contract its output only by changing the amounts of other variable inputs. The short run cost function relates to the short run production function. The total number of firms in an industry will remain the same. It is interesting to note that the relationship between the cost and output is different at two different periods of time i. When cost and output relationship is represented with the help of diagrams. It implies two sets of input components – (a) fixed inputs and (b) variable inputs. If a firm wants to produce greater quantities of output. Hence. Fixed costs in the short run remain constant because the firm does not change the size of plant and the amount of fixed factors employed.Production Analysis unit 5 2.3. MEANING OF SHORT RUN Shortrun is a period of time in which only the variable factors can be varied while fixed factors like plant. short run is defined as a period where adjustments to changed conditions are only partial. it can do so only by employing more units of variable factors or by having additional shifts. This is because a producer will get enough time to make all kinds of adjustments in the productive process in the long run than in the short run.e. variable factors are changed to vary the output in the short run.5. the plant capacity is fixed in the short run. Fixed inputs are unalterable. Time is insufficient either for the entry of new firms or exit of the old firms. Fixed costs These costs are incurred on fixed factors like land. top management etc. the costs of the firm in the short run are divided into fixed cost and variable costs. machinery etc remains constant.
these costs have to be borne by it. Prof. Hence. license fees. interest on capital borrowed. It is clear from the above description that production costs consist of both fixed as well as variable costs. property and business taxes. water etc. the distinction between fixed and variable costs is very significant in the short run because it influences the average cost behavior of the firm. Even if the firm close down its operation for some time temporarily in the short run. They include such items as contractual rent payment. Costoutput relationship and nature and behavior of cost curves in the short run In order to study the relationship between the level of output and corresponding cost of production. Variable costs directly and proportionately increase or decrease with the level of output. insurance premiums. etc. However. ordinary labor. depreciation and maintenance allowances. but remains in business. transport. The difference between the two is meaningful and relevant only in the short run. 2. they are called as indirect costs.Production Analysis unit 5 do not vary with either expansion or contraction in output. administrative expenses like manager’s salary or salary of the permanent staff. These costs are to be incurred by a firm even output is zero. even if a firm wants to close down its operation but wants to remain in business. These costs are to be distributed on each unit of output produced by a firm. it will have to incur fixed costs but it must cover at least its variable costs. Total variable costs increase with increase in the level of production and viceversa. A costschedule is a statement of a Sikkim Manipal University 127 . If a firm shuts down for some time in the short run; then it will not use the variable factors of production and will not therefore incur any variable costs. Variable costs The cost corresponding to variable factors are discussed as variable costs. These costs are incurred on raw materials. power. which directly vary in the short run. fuel. Marshall called variable costs as prime costs or direct costs because the volume of output produced by a firm depends directly upon them. Hence. Variable costs are incurred only when some amount of output is produced. Prof. we have to prepare the cost schedule of the firm. They are called as overhead costs because these costs are to be incurred whether there is production or not. In the long run all costs become variable because all factors of production become adjustable and variable in the long run. In the short run. these costs are independent of output and are referred to as unavoidable contractual cost. Marshall called fixed costs as supplementary costs.
75 84 105 540 300 210 180 60 30 168. tools & equipments in the short run. The TFC curve is horizontal and parallel to OXaxis. machinery. showing that it is constant regardless of out put per unit of time. A hypothetical cost schedule of a firm has been represented in the following table. It shows the response of cost to changes in output.75 45 156 165 105 210 On the basis of the above cost schedule. TFC starts from a point on Yaxis indicating that the total fixed cost will be incurred even if the output is zero. we can analyse the relationship between changes in the level of output and cost of production. TFC remain constant. whether 1 to 6 units. generally we study the following kinds of cost concepts and cost curves. It is the same when output is nil. Rs 30000 is TFC. In our example.Production Analysis unit 5 variation in costs resulting from variations in the levels of output. 1. Output in Units 0 1 2 3 4 5 6 TFC TVC TC AFC AVC AC MC 360 360 360 360 360 360 360 180 240 270 315 420 630 360 540 600 630 675 780 990 360 180 120 90 72 60 180 120 90 78. we get different types of cost curves in the short run. In the short run. Total fixed cost (TFC) TFC refers to total money expenses incurred on fixed inputs like plant. It indicates that whatever may be the quantity of output. Total fixed cost corresponds to the fixed inputs in the short run production function. If we represent the relationship between the two in a geometrical manner. TFC remains the same at all levels of output in the short run. It is obtained by summing up the product or quantities of the fixed factors multiplied by their respective unit price. Sikkim Manipal University 128 .
Hence. TVC curve slope upwards from left to right. variable factors are to be employed in a larger proportion to increase the same level of output. It is obtained by summing up the production of quantities of variable inputs multiplied by their prices. TVC curve rises as output is expanded. It is nil. transport and communication etc. in the short run.e. TVC = TCTFC. Thus. Total variable cost corresponds to variable inputs in the short run production function.Production Analysis unit 5 TFC = TC TVC. Sikkim Manipal University 129 . gradually in the middle and sharply at the end in accordance with the law of variable proportion. TVC is an increasing function of out put. When out put is Zero. if there is no production. fuel. power. TVC also will be zero. In other words TVC varies with output. Y Cost of production TFC 300 0 Output X 2. Total variable cost (TVC) TVC refers to total money expenses incurred on the variable factors inputs like raw materials. it is a direct cost of output. TVC = f (Q) i. relative variation in factors needed are in less proportion. The law of variable proportion explains that in the beginning to obtain a given quantity of output. the TVC curve starts from the origin. TVC rises sharply in the beginning. The formula to calculate TVC is as follows. but after a point when the diminishing returns operate. water.
a variation in TC is the result of variation in TVC since TFC is always constant in the short run. TC varies in the same proportion as TVC. Theoretically speaking TC includes all kinds of money costs. In our example the TC curve starts form Rs. In other words. The total cost is measured in relation to the production function by multiplying the factor prices with their quantities. varies with the output. TC and TVC have same shape Sikkim Manipal University 130 . Total cost (TC) The total cost refers to the aggregate money expenditure incurred by a firm to produce a given quantity of output. TC = f (Q) which means that the T. Hence. It includes fixed as well as variable costs. Output X TC = TFC + TVC Y TC Cost of production 300 TFC 0 Output x The total cost curve is rising upwards from left to right.C.Production Analysis unit 5 TVC = TC TFC Y TVC Cost of production 0 3. TC = TFC +TVC. both explicit and implicit cost. 30000 because even if there is no output. TFC is a positive amount. Normal profit is included in the total cost as it is an implicit cost.
TFC spreads over each unit of out put with the increase in output. plant capacity is fixed and output cannot be enlarged to an unlimited extent. Hence. AFC diminishes. The AFC curve has a negative slope. But AFC will never become zero because the TFC is a positive amount. AFC diminishes continuously. The curve slopes downwards throughout the length. AFC will never fall below a minimum amount because in the short run. Graphically it will fall steeply in the beginning. but never touches axis. Average fixed cost (AFC) Average fixed cost is the fixed cost per unit of output. The vertical distance between TVC curve and TC curve is equal to TFC and is constant throughout because TFC is constant. 5. it is a pure mathematical result that the numerator remaining unchanged. Average variable cost: (AVC) The average variable cost is variable cost per unit of output. TC curve is derived by adding up vertically the TVC and TFC curves. Thus. Thus AVC = TVC/Q. Mathematically speaking as output increases. the increasing denominator causes diminishing product.Production Analysis unit 5 because an increase in output increases them both by the same amount since TFC is constant. The AFC curve goes very nearer to X axis. It is higher at smaller level and lower at the higher levels of output in a given plant. Consequently. AFC = TFC/Q Y Cost of Production AFC 0 Output X AFC and output have inverse relationship. 4. When TFC is divided by total units of out put AFC is obtained. This is because as Sikkim Manipal University 131 . AVC can be computed by dividing the TVC by total units of output. The reason is simple to understand. gently in middle and tend to become parallel to OXaxis. Since AFC = TFC/Q. This relationship between output and fixed cost is universal for all types of business concerns. The AVC will come down in the beginning and then rise as more units of output are produced with a given plant.
It has three phases. As output expands. Increasing phase In the III phase. the output will be the optimum. The AVC curve is a Ushaped cost curve. AVC tends to increase. AC = TC/Q Also AC is the sum of AFC and AVC. When the proportion of both fixed and variable factors are the most ideal. c. AVC declines because when we add more quantity of variable factors to a given quantity of fixed factors. at B. i. greater output may be obtained but at much greater AVC. AVC falls and when diminishing returns set in. AVC reaches its minimum point. Constant phase In the II phase. from B to C.Production Analysis unit 5 we add more units of variable factors in a fixed plant.A) AVC = TVC / Q Y Cost of production A AVC C 0 · B Output X a. AC is also known as the unit cost since it is the cost per unit of output produced. Hence. Once the firm operates at its normal full capacity. The old proverb “Too many cooks spoil the broth” aptly applies to this III stage. the efficiency of the inputs first increases and then it decreases. AVC declines. 6. output increases more efficiently and more than proportionately due to the operation of increasing returns.e. b. Decreasing phase In the first phase from A to B. Average total cost (ATC) or Average cost (AC) Ac refers to cost per unit of output. AC is the sum of AFC and AVC. It is clear that as long as increasing returns operate. Page 198 ( B. output reaches its zenith and as such AVC will become the minimum. AVC rises when once the normal capacity is crossed. Average total cost or average cost is obtained by dividing the total cost by total output produced. This is because additional units of variables factors will not result in more than proportionate output. the AVC rises sharply. Sikkim Manipal University 132 .
As long as the falling effect of AFC is much more than the rising effect of AVC. At this stage. the AC tends to fall. AC starts rising in the third stage.Production Analysis unit 5 In the short run AC curve also tends to be Ushaped. For example. When output is expanded beyond the optimum level of output. Marginal Cost (MC) Marginal cost may be defined as the net addition to the total cost as one more unit of output is produced. ATC = AFC + AVC Y Cost of production A AC 0 · B Output C X As we observe. In other words. at the point where the rise in AVC exactly counter balances the fall in AFC. The combined influence of AFC and AVC curves will shape the nature of AC curve. the balancing effect causes AC to remain constant. the indivisible factors are used in wrong proportions. AC becomes minimum. 100 to produce 50 units of a commodity and Rs. then the AC shows a rise. In the third stage when the rise in average variable cost is more than drop in AFC. if it costs Rs. It indicates the optimum utilization of a given plant or optimum plant capacity. Thus. The short run AC curve is also called as “Plant curve”. When the firm produces the optimum output. Again. average fixed cost begin to fall with an increase in output while average variable costs come down and rise. diminishing returns set in and diseconomies of scale starts operating. increasing returns and economies of scale operate and complete utilization of resources force the AC to fall. 7. Sikkim Manipal University 133 . This is called as least – cost output level. At this stage. 105 to produce 51 units. it implies additional cost incurred to produce an additional unit.
The shape of the MC curve is determined by the laws of returns. Y Cost of production A MC B · C 0 Output X The table indicates the relationship between AC & MC Output in Units TC in Rs. AC in Rs. MC 1 2 3 4 5 150 190 220 236 270 150 95 73.Production Analysis unit 5 then MC would be Rs. In the short run. Difference in Rs. the MC curve also tends to be Ushaped. production will be subject of diminishing returns. MC = D TC / D TQ. It is obtained by calculating the change in total costs as a result of a change in the total output. If MC is falling. 5. Where D TC stands for change in total cost and D TQ stands for change in total output. Also MCn = TCn –TC n1 It is necessary to note that MC is independent of TFC and it is directly related to TVC as we calculate the cost of producing only one unit. Also MC is the rate at which total cost changes with output.3 59 54 40 30 16 34 Sikkim Manipal University 134 . production will be under the conditions of increasing returns and if MC is rising. Hence.
MC curve lies below AC curve.2 54 91 165 Relation between AC and MC Y AC MC Cost · AC=MC Output X From the diagram it is clear that: 1. Hence. So long as AC is falling. Both MC and AC fall at a certain range of output and rise afterwards. It indicates that fall in MC is more than the fall in AC. MC would be less than AC. MC reaches its minimum point before AC reaches its minimum. the decreasing AC is distributed over all the units of output produced. MC also falls but at certain range of output MC tends to rise even though AC continues to fall. 2. Sikkim Manipal University 135 . This is because MC is attributed to a single unit where as in case of AC.Production Analysis unit 5 6 7 8 324 415 580 54 59. MC is less than AC. However.3 72. When AC falls. 3.
MC is greater and AC. MC will be greater than AC. In the long run only the average total cost is important and considered in taking long term output decisions. 6. when MC decreases. When AC is at its minimum. after the point of intersection. So long as the AC is rising. MC = AC. the increasing MC is attributed to a single unit. if demand for the product declines. the increasing AC is distributed over all the output produced. It is actually a period during which the quantities of all factors. The point of intersection indicates the least cost combination point or the optimum position of the firm. it is the per unit cost of production of different levels of output by changing the size of the plant or scale of production.3. a firm can cut down its production permanently. In the short run. it pushes AC up. It indicates that rise in MC is more than the rise in AC.6 Cost Output Relationship In The Long Run Long run is defined as a period of time where adjustments to changed conditions are complete. employ administrative and other permanent staff. the distinction between fixed and variables costs in the total cost of production will disappear in the long run. where as in case of AC. install new machines. but in the long run it is not tied up to a particular plant capacity.Production Analysis unit 5 4. there is scope for “Maximum Capacity” with rising cost. there are no fixed costs in the long run. On the other hand. Long run average cost is the long run total cost divided by the level of output. Sikkim Manipal University 136 . variable as well as fixed factors can be adjusted. When AC is minimum. When AC is rising. it pulls AC down and when MC increases. MC curve cuts the AC curve at the minimum point of the AC curve. It can make use of the existing as well as new staff in the most efficient way and there is lot of scope for making indivisible factors to become divisible factors. the total of these costs is total cost of production. In brief. The size of the plant can also be reduced and other expenditure can be minimized. Hence. it can expand output by enlarging its plant capacity. Hence. Hence. It can construct new buildings or hire them. AC curve lies to the left side of the MC curve. At output Q the firm is working at its “Optimum Capacity” with lowest AC. it is neither being pulled down or being pushed up by the MC. production cost comes down to a greater extent in the long run. a firm has to carry on its production within the existing plant capacity. As all costs are variable in the long run. 5. Hence. Thus. Beyond Q. This is because in case of MC. If demand for the product increases. 5. This is because.
one has to draw a number of SAC curves. Y LAC SAC 1 SAC 2 SAC 3 SAC 4 SAC 5 Cost of Production 0 Output Q X Q The long run cost curves are influenced by the laws of return to scale as against the short run cost curves which are subject to the working of law of variable proportions. In order to derive LAC curve. In the long run as it is possible to alter the scale of production. There will be only one AC curve to represent one fixed scale of output in the short run. each curve representing a particular scale of output. The LAC curve will be tangential to the entire family of SAC cures. one can have as many AC curves as there are changes in the scale of operations. In the short run the firm is tied with a given plant and as such the scale of operation remains constant.Production Analysis unit 5 The long run cost – output relationship is explained by drawing a long run cost curve through short – run curves as the long period is made up of many short – periods as the day is made up of 24 hours and a week is made out of 7 days. This curve explains how costs will change when the scale of production is varied. Sikkim Manipal University 137 . It means that it will touch each SAC curve at its minimum point.
LAC curve is locus of all these points of tangency. M3 is the short run AC because. They represent three different scales of output. When output is to be expanded to OM3. Similarly. K1M1 will become the short run AC and L1M1 will be the long run AC. K1L1 indicates the differences between short run and long run cost of production. For output OM3 the AC will be L2M2 in the short run as well as the long run. the LAC curve is drawn on the basis of three possible plant sizes. Hence. If we join points L1. SAC2 and SAC3.Production Analysis unit 5 Production cost difference in the short run and long run Y SAC 2 Cost of Production SAC 1 SAC 3 LAC · K 1 · K 3 · L1 · L2 · L3 0 M1 M2 Output M3 X In the diagram. But the same output of OM3 can be produced at a lower AC of L3M3 in the long run since the scale of production can be modified according to the requirements. when output is contracted to OM1 in the short run. no SAC curve Sikkim Manipal University 138 . we have three different SAC curves – SAC1. The distance between K3L3 represent difference between the cost of production in the short run and long run. This implies that for any given level of output. scale of production would remain constant in the short run. K3. it can be obtained at a higher average cost of production. Important features of long run AC curves 1. Tangent curve Different SAC curves represent different operational capacities of different plants in the short run. L2 and L3 we get LAC curve. The SAC curve can never cut a LAC curve though they are tangential to each other. Consequently.
This is because LAC can never be higher than SAC or SAC can never be lower than LAC. Planning curve. At OM2 output LAC = SAC. Optimum scale plant is that size at which SAC is tangent to LAC. 4. This is possible when the entrepreneur is selecting the optimum scale plant. SAC cannot be lower than the LAC in the ling run. Hence. LAC gradually falls and rises due to economies and diseconomies of scale. The LAC curve will touch the optimum plant SAC curve at its minimum point. The LAC curve is also U shaped or dish shaped cost curve. Flatter Ushaped or dishshaped curve. SAC curves are either rising or falling indicating a higher cost Managerial Use of LAC The study of LAC is of greater importance in managerial decision making process. OM2 is regarded as the optimum scale of output. Sikkim Manipal University 139 . neither LAC is minimum nor will SAC be minimum. Thus. But It is less pronounced and much flatter in nature. 1. 5. This helps in producing optimum level of output at the minimum LAC. 2. as it has the least per unit cost. such that both the curves have the minimum point of tangency. A rational entrepreneur would select the optimum scale plant. Optimum scale plant is that size where the minimum point of SAC is tangent to the minimum point of LAC. LAC curve is tangential to various SAC curves. 3. LAC curve will be tangent to SAC curves lying to the left of the optimum scale or right side of the optimum scale. In the diagram.Production Analysis unit 5 can ever be below the LAC curve. Envelope curve It is known as Envelope curve because it envelopes a group of SAC curves appropriate to different levels of output. The LAC cure is described as the Planning Curve of the firm because it represents the least cost of producing each possible level of output. But it is interested in producing a given output at the minimum cost. Minimum point of LAC curve should be always lower than the minimum point of SAC curve. But at these points of tangency. It helps the management in the determination of the best size of the plant to be constructed or when a new one is introduced in getting the minimum cost output for a given plant.
An optimum size of plant is one that helps in best utilization of resources in the most economical manner. therefore. similarly the LMC is related to the LAC and.. at output beyond the optimum level. we can derive the LMC directly from the LAC. 3.e. Just as the SMC is related to the SAC. Thus. The LAC curve helps a firm to decide the size of the plant to be adopted for producing the given output. Long Run Marginal cost Y LMC SMC 3 LAC E Cost of Production SMC 1 SAC 1 A SMC 2 SAC 2 SAC 3 D B C 0 N Q Output R X A longrun marginal cost curve can be derived from the longrun average cost curve. Conversely.Production Analysis unit 5 2. it explains why it is more economical to over use a slightly small plant rather than to under use a large plant. when the firm is working subject to increasing returns to scale. In the diagram we have taken three plant sizes (for the sake of simplicity) and the corresponding three SAC and SMC curves. LAC is used to show how a firm determines the optimum size of the plant. For outputs less than cost lowering combination at the optimum scale i. it is more economical to under use a slightly large plant operating at less than its minimum cost – output than to over use smaller unit. that is when the firm experience decreasing return to scale. The LAC curve is drawn by enveloping the family Sikkim Manipal University 140 . it is more economical to over use a slightly smaller plant than to under use a slightly larger one.
In other words. The LMC will pass through point B. Or TC = TFC + TVC ¨ TFC = TC TVC or AFC x Q ¨ TVC = TC – TFC or AVC x Q or addition of MC ¨ AFC = AC – AVC or TFC/Q ¨ AVC = AC – AFC or TVC/Q ¨ AC = AFC + AVC or TC/Q ¨ MC = TCn TCn1 or D TC / D TQ. Marginal cost deals with changes in cost of ______ unit where as incremental cost deals with changes in cost of ________. it will have to choose the plant size corresponding to SAC1. At point C. If the firm wants to produce ON output in the long run. Opportunity cost of anything is the alternative that has been _____ 2. the corresponding LMC curve will have to be equal to SMC1 curve at point B. If output OQ is to be produced in the long run. COST OF PRODUCTION: FORMULAS ¨ TC = cost per unit x total production. The LMC curve will.at point D the LAC is tangent to SAC3. the LAC for output OQ is QC and the corresponding LMC is also QC. AC minus AVC would give us _________ Sikkim Manipal University 141 . For OR output at point E LMC is passing through SMC3. 3. it will be done at point c which is the point of tangency between SAC2 and the LAC. therefore. therefore pass through point C. The LAC curve is tangent to SAC1 at point A. we can draw the longrun marginal cost curve. By connecting points B .Production Analysis unit 5 of SAC curves. For ON output. for output OR.C and E. The points of tangency between the SAC and the LAC curves indicate different outputs for different plant sizes. the short –run average cost (SAC2) and the shortrun marginal cost (SMC2) are equal and. Finally. where LAC is equal to SAC curve (for a given output) the LMC will have to be equal to a given SMC. Self Assessment Questions 2 1. the average cost is NA and the corresponding marginal cost is NB If LAC curve is tangent to SAC1 curve at point A.
5. Cost function explains the relationship between the amounts of costs to be incurred to produce a particular quantity of output. In the long run all cost are ______________. The ratios between the two quantities are of great importance to a producer to take his decisions in the production process. Total cost include ___________ profits. Short run cost function gives information about the nature and behavior of various cost curves. Economies of scope on the other hand tells us how there will be certain specific advantages when one firm produces more than two products jointly than two or three firms produce them separately. 5.4 Summary In this unit5 we have discussed about the meaning of production. production function and its managerial uses. On the other hand IsoQuants and Isocost curves explain how there will be changes in output when only two variable inputs are changed while all other inputs are kept constant. The various kinds of cost concepts help a manager to take right decisions. Diseconomies of scale and diseconomies of scope tells us that there are certain limitations to expansion in output Cost analysis on the other hand. Thus. Marginal cost is associated with _________ costs. Long run cost function tells us how it is possible to obtain more output at lower costs in the long run. 6. the knowledge of both production function and cost functions help a business executive to work out the best possible factor combinations to maximize output with minimum costs. The law of variable proportion explain how there will be variations in the quantity of output when there is change in only one variable factor inputs while all other inputs are kept constant. Sikkim Manipal University 142 . indicates the various amounts of costs incurred to produce a particular quantity of output in monetary terms.Production Analysis unit 5 4. Economies of scale give information about the various benefits that a firm will get when it goes for large scale production. Production function explains the quantitative relationship between the amounts of inputs used to. In case of short run production function we come across a change in either one or two variable factor inputs while all other inputs are kept constant. Production in economics implies transformation of inputs into outputs for our final consumption. Under long run production function.. There are two kinds of production functions short run and long run. both variable as well as fixed changes in the same proportion. get a particular physical quantity of outputs. the laws of returns to scale explain changes in output when all inputs.
Explain features of LAC curve with a diagram. Explain how a product would reach equilibrium position with the heap of ISO Quants and ISO cost curve. Highest 5. Technological. 5. 2. 2. 3. One product jointly Sikkim Manipal University 143 . Various alternative. 3. 4. addition. 8. Total fixed cost to output b. 6. engineering. Answer to Self Assessment Questions Self Assessment Questions 1 1. 7. Total cost to output 11.Production Analysis unit 5 Terminal Questions 1. Variable. Explain cost output relationship with reference to a. particular 6. Give a suit description of a. Discuss the various determinants of costs. Explain the law of variable proportions 4. Explain either various internal or external economics of scale. Implicit and explicit cost b. Total variable cost to output c. New utilities. Firms industry 8. Discuss the user of production function. Discuss any one laws of returns to scale with example. Actual and opportunity cost 9. Demanding returns 7. 10. Explain the concept of economic of scope with suitable illustration. Define production function and distinguish between shortrun and long run production function.
Production Analysis unit 5 Self Assessment Questions 2 1.5 5. one .3 3.2 2.2 9. foregone 2.6 Sikkim Manipal University 144 . normal 5.2.4 4.3 10. Variable Answer to Terminal Questions 1. Refer to unit 5. Refer to unit 5. Refer to unit 5. Refer to unit 5.5 11.6 6. Variable 6. Refer to unit 5.7 7.2.2. Refer to unit 5. Refer to unit 5.2. Refer to unit 5. a group of units 3. AFC 4. Refer to unit 5. Refer to unit 5.11 8. Refer to unit 5.
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