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PRINCIPLES OF

ECONOMICS
MIDTERM 02

Production.

Transformation of inputs into outputs. Inputs are what a firm buys (i.e.,
productive resources) and outputs are what it sells (i.e., goods and services).
Production is defined as creation of utility and more precisely,
creation/addition of value. Production is creation of utility.

Production Function.

Production function is defined as the functional relationship between


physical inputs (i.e., factors of production) and physical outputs, i.e., the
quantity of goods produced.
Production function may be expressed as under:
Q = f (K, L)
Where;
Q = Output of commodity per unit of time.
K = Capital.
L = Labor.
f = Functional Relationship.

Marginal product.

Output that results from one additional unit of a factor of production (such
as a labor hour or machine hour), all other factors remaining constant is
known as marginal product. Whereas the marginal cost indicates the added
cost incurred in producing an additional unit of output, marginal product
indicates the added output accruing to an additional input.
Marginal product of capital MPk = dQ/dK = AK 1L and
Marginal product of labor MPL = dQ/dL = AKL 1

Law of diminishing marginal return.

An economic principle that states that while increasing one input and keeping
other inputs at the same level may initially increase output, further increases
in that input will have a limited effect, and eventually no effect or a negative
effect, on output. The law of diminishing marginal productivity helps explain
why increasing production is not always the best way to increase profitability.

Total, Average and Marginal Products.

Ten equally skilled and diligent workers are ready to work in a factory
equipped with machines and ready stock of materials. As workers add in, the
output increases and figures on the number of workers, total product,
average product and marginal product can be shown as under:

Average Product = (Total Product)/ (Variable Inputs Employed)


Marginal Product (MP) = change in output Associated with one-Unit change
in workers
MP = Q/L, Q = amount of output, L = No of workers

Producers equilibrium.

Equilibrium refers to a state of rest when no change is required. A producer is


said to be in equilibrium when it has no inclination to expand or to contract
its output. This state either reflects maximum profits or minimum losses
which can be attained either by minimizing costs or maximizing sales.

What is iso-quant?

Iso-quant represent all these combinations of two resources which give same
level of output. Isoquant is one way of presenting the production function
where two factors of production are shown. It represents all possible input
combinations of the two factors, which are capable of producing the same
level of output. As the production remains the same on the point of this
contour line, it is also called the equal product curve. Isoquants generally
slope downward, are convex to the origin and do not intersect each other.
Let, Q = f (L, K) is the production factor.
L = Labor & K= Capital

This curve indicates that a firm can produce the specified level of output from
input combinations (L 1 , K 1 ), (L 2 , K 2 ), (L 3 , K 3 ), a b c. As we move down

from one point on an isoquant to another, we are substituting one factor for
another while holding output constant.

Budget Line.

A graphical depiction of the various combinations of two selected products


that a consumer can afford at specified prices for the products given their
particular income level.
Schedule:
Here it is assumed that the consumer has a money income of Rs.5.The price
of one unit of commodity is Rs.1. In first case the consumer buys 5 units of A
& 0 units of B likewise 4 units of A & 1 units of B so on so forth until 0 units of
A & 5 units to B.

Commodity A
5
4
3
2
1
0

Commodity B
0
1
2
3
4
5

Joining these points (as seen below) will result in a straight line called as
Budget Line or Price Line (PL).It is popularly known as 'Price Line'.

Laws of Returns.

There are three laws of returns: Law of diminishing, increasing and constant
returns. However, they are only three aspects of one law viz., the law of
variable proportions.
According to law of diminishing returns applicable in agriculture successive
application of labor and capital to a given area of land must ultimately, other
things remaining the same, yield a less than proportionate increase in
produce.
An industry is subject to law of increasing returns if extra investment in the
industry is followed by more than proportionate returns i.e., the marginal
product increases (with lowering of marginal cost). This may happen by
specialization of machinery and labor.
The Law of constant returns says that increased investment of the labor and
capital results in a proportionate increase in output and whatever the output
or scale of production, the cost per unit remains unaltered.

Returns TO SCALE.
Returns to Scale refers to the effect of doubling, trebling, and quadrupling
and so on of all the inputs on the output of the product, a situation when all
the productive forces are increased or decreased simultaneously in the same
ratio.

Returns to scale answer the question: If labor, capital, and other inputs ALL
increase by the same proportion (say 10 percent) does output increase by
more than, less than, or equal to this proportion (more than 10 percent, less
than 10 percent, or exactly 10 percent)? The answer indicates that returns to
scale can take one of three forms: increasing returns to scale, decreasing
returns to scale, and constant returns to scale.

Increasing Returns to Scale: This occurs if a proportional increase in all


inputs under the control of a firm results in a greater than proportional
increase in production. In other words, a 10 percent increase in labor,
capital, and other inputs, results in a production increase that is greater
than 10 percent.
Decreasing Returns to Scale: This occurs if a proportional increase in all
inputs under the control of a firm results in a less than proportional
increase in production. In other words, a 10 percent increase in labor,
capital, and other inputs, results in a production increase that is less
than 10 percent.
Constant Returns to Scale: This occurs if a proportional increase in all
inputs under the control of a firm results in an equal proportional
increase in production. In other words, a 10 percent increase in labor,
capital, and other inputs, results in an equal 10 percent increase in
production.

Distinguish between the concepts of returns to scale


and laws of return.

1.
Laws of returns refer to situations when some factors may be increased
or decreased and at least one factor remains unchanged.
While returns to scale refers to a situation when all factors change
simultaneously in a given proportion.
2.
In laws of returns, the possibility in production expansion is very
limited. It can be expanded until its factor marginal product becomes zero.
The returns to scale, at the other hand, can be expanded at all level because
all factors become variable in the long-run.

3. In laws of returns, concepts of total product, marginal product and average


product are discussed.
In returns to scale, the concept of isoquant and iso-cost are used.

Economies of Scale.

Economies of scale may be understood as the benefits obtained because of


increase in the size of the firm/output. If the scale changes (to a large
proportion) economies take place because of lowering unit costs or increased
productivity as a result of specialization of labor and inventory. There may be
diseconomies, too. For example, transportation cost may go high, wage rates
may be increased (due to increased demand of labor for the large scale
industry) etc.
An economic concept referring to a situation in which economies of scale no
longer function for a firm. Rather than experiencing continued decreasing
costs per increase in output, firms see an increase in marginal cost when
output is increased.

Why do increasing returns to scale occur?

1. Specialization and division of labor: In large scale operations workers can


do more specific tasks. With little training they can become very proficient in
their task, this enables greater efficiency. A good example is an assembly line
with many different jobs.
2. Technical: Some production processes require high fixed costs e.g. building
a large factory. If a car factory was then only used on a small scale it would be
very inefficient to run. By using the factory to full capacity average costs will
be lower.
3. Financial economies: A bigger firm can get a better rate of interest than
small firms.
4. Spreading overheads: If a firm merged it could rationalize its operational
centers. E.g. it could have one head office rather than two.

5. Marketing Economies of scale: There is little point a small firm advertising


on a national TV campaign because the return will not cover the high sunk
costs.

When do decreasing returns to scale occur?

Control monitoring the productivity and the quality of output from


thousands of employees in big corporations is imperfect and costly.
Co-operation - workers in large firms may feel a sense of alienation and
subsequent loss of morale. If they do not consider themselves to be an
integral part of the business, their productivity may fall leading to wastage of
factor inputs and higher costs. A fall in productivity means that workers may
be less productively efficient in larger firms.
Loss of control over costs big businesses may lose control over fixed costs
such as expensive head offices, management expenses and marketing costs.
There is also a risk that very expensive capital projects involving new
technology may prove ineffective and leave the business with too much
under-utilized capital.

Economies Of Scope.

Economies of Scope: An economic theory stating that the average total cost
of production decreases as a result of increasing the number of different
goods produced. For example, McDonalds can produce both hamburgers and
French fries at a lower average cost than what it would cost two separate
firms to produce the same goods. This is because McDonalds hamburgers and
French fries share the use of food storage, preparation facilities, and so forth
during production.

Economies of large-scale production.


Efficient use of capital equipment;
Economy of specialized labor (through division of labor);

Better utilization/greater specialization in management;


Economies of buying and selling; Economies of overhead charges;
Economy in rent; Experiments and research
Advertisement and salesmanship;
Utilization of by-products;
Meeting adversity;
Cheap credit

Internal and External Economies.

Internal economies are those economies of production which occur to the


firm itself when it expands its output or enlarge its scale of production.
Technical economies (large size, linkage process, superior techniques,
increased specialization);
Managerial economies (functional specialization and delegation of
routine and detailed matters to subordinates);
Commercial economies (bargaining advantage of large firms in
purchase deals, procurement of credit etc.);
Financial economies (large firms can borrow more, and on more
favorable terms);
Risk bearing economies (large firm can spread risk and even eliminate
them).
External economies of scale occur when businesses are able to lower their
per-unit costs of producing goods or services by increasing production.
Economies of concentration (arising out of availability of skilled worker,
provision of better transport and credit, advantage of localized
industries etc.);
Economies of information (publication of trade journals, dissemination
of research etc.);
Economies of disintegration (splitting of some processes for taking up
by specialist firms).

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