THE PRODUCTION PROCESS

Production is a process in which economics resources or inputs are combined by entrepreneurs to create economic goods and services

THE PRODUCTION FUNCTION

The task of a production unit is to organise a production process a process of combining the different factors in some proportion so that those inputs can be efficiently transformed into products or outputs.

The production function

INPUTS Factors Factors of production Resources

OUTPUTS Quantity (Q) Total product(P) Product

Mathematical statements

Where Q=Output, X1 X2 =Inputs used For the purpose of analysis, the equation can be reduced to two inputs X and Y. Q=f(X,Y) Where Q=output X=Labour Y=Capital

Q=f(X1,X2 ...........................XK)

The production function defines the relationship between inputs and the maximum amount that can be produced within a given period of time with a given level of tecnology

The Nature of production

1.

2.

3.

4.

The production function is purely technological. Production function is a continuous function Production function has economic importance Production functions differ from firm to firm and industry to industry

Purely technological

Differ from firm to firm

Nature of production function

Continuous function

Economic Importance

Types of production function

1.

2.

3.

Fixed proportion and variable proportion production function Short period and long period production function Cobb-Douglas production function.

The fixed proportion production function

Variable proportion production function

C a

p y1
i t

a b c 100 200 300

y2 a y3 l o x1 x2

x3

Labour

Production function through Iso-Quants analysis

Iso-Quant curve It is a concept which tells that the quantity produced will be same inspite of variation in production. There may be different combination of inputs. Each combination is called a scale of preference. Each scale when applied will produce the same quantity of output. Thus, Iso-Quant (which means equal quantity) curve indicates that each curve will have different scales of preference of input which can produce the same quantity of ouput

ILLUSTRATION

Two variables inputs namely capital (k) and labour(l) are considered. Total output is Rs 100 labour cost is Rs 10 per unit and capital cost is Rs 30 per unit some alternative combinations are as follows: Combination Capital Labour 1 3 1 2 2 4 3 1 7

Plotting the above cost combination we get the isocost line as follows

5 4

3
2 1

1 2 2 3 4 5 6 7 8

When outlay is increased prices of factors remaining unchanged, factor combination will change with more quantities of factors being purchased. For each increase in total outlay the isocost lines will be different and shift upwards. Prices of factors remaining unchanged the isocost lines will have parallel shifts.

Properties of isoquants
1 Isoquants are convex to origin: The slope of the isoquant

2 3

4 5

measures, the marginal rate of technical substitution of one factor input(say labour) for other factor input(say capital). Isoquants are negative slope: This means that in order to maintain a given level of output when the amount of one factor input is increased other must be decreased. Isoquants never intersect each other: This is necessary because by definition each isoquant represents a specific quatum of output. Therefore if two isoquants intersect each other it would involve logical contradiction as particular isoquant at time may be representing a small as well as a large quantity of output. Isoquants never touch axis: Isoquants do not intercept either axis because if it touches it would mean that output is possible by using single factor, but this is unrealistic. Sometimes isoquants are oval shape: One isoquant may have positive upwards slope at its ends. When with relatively small amount of factor realtive large amount of factor is combined marginal productivity of abundant tends to be negative and as such resulting in decline of total output. In such cases the end positions of curves are called uneconomical.

Marginal rate of technical substitution (MRTS)

The producers substitute are input in the place of other in the production process. The substituting of one input for another without changing the level of output is called as marginal rate of technical substitution. The scope of isoquant is measured in terms of MRTS. The MRTS of factor x(labour) for a unit of factor (y) which can be subsituted or replaced for a unit of x without changing the level of output. The terms of inputs (K) and labour (L).

MRTS is similar to MRC marginal rate of substitution in indifference curve analysis MRTS dimnishes always.

EQUILIBRIUM OF THE FIRM CHOICE OF OPTIMAL COMBINATION OF FACTORS

A producer or a firm is said to be in equilibrium when it is able to produce more output with given outlay and given factors of production. A rational producer may attain equilibrium either by maxmising output for a given cost or minimising cost subject to a given level of output. In order to determine the producers equilibrium we should intergrate an isoquant map with isocost line.

An isoquant is the locus of all combinations of two factors of production that yield same level of satisfaction. Isoquant map refers to a group of isoquants each representing different levels of output. An isocost line represents various combinations of two inputs that may be purchased for a given amount of expenditure.

Maximisation of output for a given cost.

A rational producer will always try to maxmise his output for given cost. This can explained with the help of a diagram. Suppose the producers cost outlay is C and the prices of capital and labour are i and w respectively. Subject to these cost conditions the producer would attempt to attain the maximum output level.

OPTIMAL FACTOR COMBINATION TO MAXIMISE OUTPUT LEVEL.

Y

A
C A P I T A L

IQ3 (3000) E IQ2 (2000) IQ1 (1000) O Labour B

Let AB in the figure represents given cost outlay .IQ1,IQ2,IQ3 are isoquants representing three different levels of output IQ3 level of output is not attainable because it is out of reach of producer .In fact any output level beyond isocost line AB is not attainable .The producer firm reaches equilibrium position at point E at this stage he employs OK amount of capital and OL of labour. The aim of producer is to maximize his output with given cost outlay he will prefer only point E and not any other point on isocost line.

Minimisation of cost for a given level of output

The producer or the firm may minimize the cost of producing a given amount of output. In both the cases the condition of equilibrium remains the same. That is the MRTS must be equal to factor price ratio. MRTSLK=w/i=Pl/Pk Where, W=wages (price for labour) i=interest (price for capital) pl =Price of labour pk=price of capital

C
A P I

A3 A2 A1 K E G IQ (2000)

T
A L

B1

B2

B3

LABOUR

of isocost lines representing various levels of total cost outlay (A1B1, A2B2, A3B3).The isocost lines Here , we have one isoquant representing given level of output(i.e 2000 units) and a set are parallel, and thus have the same scope because they have been drawn on the assumption of constant price of factors. The iso-cost line,AB is not relevant because the output level represent by the iso-quant IQ2 (i.e. 2000units) is not producing by any factor combination F and G on A3B3 isocost line. But he can also produce the same level of output at point E (equilibrium) on A2B2 isocost line at a lower cost. Since the producers aim is to minimize the cost, he will choose the point E rather than F and G because these two points lie on the higher cost outlay. Therefore, the producer by employing OK of capital and OL of labour can reach the equilibrium E by minimizing the cost for a stipulated output (2000 units).

EXPANSION PATH: (Choice of optimal expansion path)

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

Y F

C P

A
e3 e2 K e1 IQ3 (3000) IQ2 (2000) IQ3(1000)

B LABOUR

Units of labour employed is measured along the X axis and capital employed is measured along the Y axis. The first iso-cost line of the firm is AB. It is tangent to IQ at point E, which is the initial equilibrium of the firm. Supposing the price per unit of labour and capital remains unchanged and the financial resources of the firm increases, the firms new iso-cost line shifts to right as CD. In this situation new iso-cost line CD will be parallel to the initial iso-cost line AB and tangent to IQ2 at point E2 which will be the new equilibrium point now. If the financial resources of the firm further increases, but the price of the factors remaining the same, the iso-cost line will be FG. It will be tangent to the iso-quant IQ 3 at point E3 which will be the new equilibrium point of the firm. By joining all the equilibrium points we get a line(PP) called scale-line or expansion path. It is called so because a firm expands its output or scale of production in conformity with this line.

COST MINIMISATION

The firm wants to produces any amount of output at the least cost. This is obtained by point of tangency of the isoquant to an ISO cost line. In other words, minimum cost mean that Isoquants are tangents to ISO cost lines.

Y C3 C A C2 P B

I
T

C1
M N

L IQ2 IQ3

IQ3

A Y1 L

X1

D1 LABOUR

D2 D3

In the above diagram the maximum output is obtained at a point of tangency between isoquant and ISO cost lines. N,M,L are the points of tangency. The firm expands output along the line D. At the point of N output, the firm buys OX| and OY| inputs. This is the optimal combination of inputs. At this point, the marginal rate of substitution between inputs is equal to the ratio between the prices of the inputs. The minimum cost represented by the point of tangency between the isoquant and ISO cost line.,

Uses of production function

1.

2.
3. 4. 5.

To know least-cost combination. To maxmise production. To attain equilibrium. Helps in decision making. Basis for production planning.

Production function one variable input:Short run analysis(Law of variable proportion)

The law of variable proportion occupies very important place in ME because it examines the production function with one variable input keeping the other inputs fixed when quantities of one input is varied keeping other inputs constant the proportion between fixed factor and variable factor is altered when combination of inputs are thus altered the resulting output changes .The effect of output of variations in factor proportions is called law of variable proportions. The law states that as more and more of factor input is employed all other input quantities remaning constant a point will eventually be reached where additional quantities of varying input will yeild deminishing contributions to total products .

Assumptions
1.

2.

3.

The state of technology of production remains unchanged Some inputs are kept fixed during the process of production.It is only in this way that factors proportions are altered to know its effect on output The law is based on the possibility of varying proportion in which various factors can be combined to produce a product.

Illustrations of law
No of workers 1 2 3 4 5 6 7 8 (x) output(o) 8 17 27 36 43 48 48 46 Average product o/y 8 8.5 9 9 8.6 8 6.8 5.7 Marginal Product 8 9 10 9 7 5 0 -2 Stages

Increasing returns-I Decreasin g returnsII Negative Returns-II

From total output average output can be derived. Marginal product is the addition to total product which can be produced by addition of more units of variable input. Average output is the ratio of total output to amount of variable input. The behaviour of the total average and marginal output is shown in the diagram.

Increasing returns stage:

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

Decreasing returns stage

In the stage II,The total product contines to increase,but at a diminishing rate. When the marginal product is zero,the total product is the maximum. In this stage both AP & MP are declining. MP being below the average product,pulls the agerage product down. At the end of the second stage at the poing M,the marginal product to the variable product inputs become zero,while the total point reaches the heighest point. This stage is called the stage of deminishing returns as both the average and marginal products of the variable factor continuously fall.

Negative returns stage

In the stage III,total product declines and therefore the total product curve slopes downword. As a result,the marginal product is negative and the MP curve goes below OX axis. The average product decreases still further. It shows that the variable factor is toomuch to mixed factor. This stage is called the stage for negative returns. It may be noted that the stage I and III are completely symmetrical. In the stage I,fixed factor is toomuch relative to the variable factor. In this stage marginal product of the fixed factor is negative. On the other hand,in the stage III,variable factor is toomuch relative to the fixed factor. Therefore marginal product of the variable product is negative.

The stage of operation

The question is which stage of operation is rational to production. A rational producer will not choose to produce in the stage III. At the end of stage II at the point M,the marginal product and thus will be making the maximum use of the variable factor. In the stage I,the producer will not be making maximum use of fixed factor and he will not be utilising fully the opportunities of increasing production by increasing the quantity of variable product,whose average product continues to raise throughout the stage I. Thus a rational producer will not stop in the stage I,but will expand further. At point N the marginal product to the variable factor is the maximum and the end point N of the stage I,he will be making maximum use of the fixed factor. So long as the average product,marginal product and total product are raising,the entrepreneur will not stop producing. Therefore he goes to stage II,where both marginal product and the average product of the variable factor are deminishing. The stage II represents the range of rational production decisions.

The laws of returns to scale(Long run)

The laws production describe the technically possible ways of increasing the level of production. These show how the input can be increased by changing the quantities of factor inputs. In the short run only one factor can be altered, keeping the other factor unchanged. It is because ,in the short period, fixed factors like machinery cannot be altered. But it is possible to alter the fixed factors in the long period. The laws of returns to the scale refers to the long run analysis of production.

The laws of returns to scale are entairly different from the laws of variable proportion. In the laws of returns to the scale,all productive factors or inputs are increased or decreased in the same proportion simeltaneously. In returns to scale,we analyses the effect of doubling or tribling,quadrupling and so on of all inputs from the output of the product. The study of changes in the output as a consequence of changes in the scale,forms the subject matter of returns to scale.

The three phases of returns to scale

Producers who have not studied economic analysis think that output can be doubled by doubling all the inputs or trible the output by tribling all the productive inputs. But actually this is not so. In other words,actually the output are returns donot increase/decrease strictly according to the change in the scale. If the increase in the output is proportional to increase in the quantities of input,returns to scale are said to be constant. It means that a doubling of inputs causes a doubling of output. If the increase in output is more than the proportional,returns to scale are increasing and if the increase in output is less than proportional,returns to scale to scale re deminishing.

Returns to scale
S.No. Scale of inputs Total Marginal product product or returns 2 5 9 14 2 3 4 5 Stage

1 2 3 4

1 worker + 3 acres of land 2 workers + 6 acres of land 3 workers + 9 acres of land 4 workers + 12 acres

Increasing returns-I

5 6
7 8 9

5 worker + 15 acres 6 worker + 18 acres

7 worker + 21 acres 8 worker + 24 acres 9 worker + 27 acres

19 24
28 31 33

5 5
4 3 2

Constant returns-II
Diminishing returns-III

Illustration
In the table,it can be sean that as all the factor inputs are together increased to the same extent,the marginal product or returns increases first up to a point then constant for some further increase in the scale and ultimately starts declining. At the s.cale of 1 workers +30 acres of land,the total product is 2 quintals. To increase the output,the scale is doubled,the total increases to more than double(5 quintals instead of 2 quintals). When the output is tribled,the output increaes to 9 quintals,the increase this time being 4 quintals instead of 3 quintals. In other words,the return to scale is increasing. If the scale of production is further increased,the marginal product remains constant upto a certain point and behyond it,it starts deminishing.

Increasing returns to scale

Increasing returns to scale means that output increases in a great proportion than increase in inputs.If for example all inputs are increased by 25 percent,the output increases by 40 percent,then the increasing returns to scale is prevaililng.When the firm is expanding ,increasing returns to scale obtained in the beginning.One chief reason for this increase is the effect of technical and managerial indivisibility.Indivisibility means that equipment is available only in minimum sizes and the firm has to start producing from the minimum size of equipment.In the beginning the firm will not be in a position to use the equipment to its optimum capacity.In other words ,the equipments are underutilized in the beginning.When the scale of operations are increased,they are input into maximum use and hence the output are return increases more than proportiionately.

6 Marginal product 5 4

Stage II

3
2 1
Marginal products or returns

10

Scale

Constant returns to scale

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

Such industries said to be goverened by the law of constant returns.

Diminishing returns to scale

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

Empirical production function

There are five types of linear and non-linear models of production functions used in empirical studies.

LINEAR PRODUCTION FUNCTION. QUADRATIC PRODUCTION FUNCTION. CUBIC PRODUCTION FUNCTION. POWER PRODUCTION FUNCTION. COBB DOUGLAS PRODUCTION FUNCTION.

Linear production function.

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

AP=MP

The value of b0 intercept parameter in the shortrun production function refers to the fixed factor input quantity b1 the slope coefficient represents the marginal product (MP) the variable factor. It being constant also represents the average product (AP). As such AP=MP when MP is constant, the marginal and average product curves are horizontal straight lines, which tend to coincide.

Quadratic production function

It is stated as follows Q=b0+b1V-b2V2 This equation measures downward slope of the AP and MP curves as shown below. It is useful to know the quantum diminishing returns.
Q

AP

MP

Cubic production function

It is stated as follows Q=b0+b1V+b2V2-b3V3 This function highlights the law of non proportional returns to the variable factors. Graphically it shows that the marginal product(MP) curve is initially raising and then falling. Also the MP curve intersects the AP curve at its maximum point.

Power production function

It is stated as follows Q=aVb where Q=the output a=constant parameter b=power V=variable factor input Logarithmically, its linear form is as follows log(Q) = log(aV b) log Q = log a + log (Vb) log Q = log a + b log V

Cobb-Douglas production function

All the above stated production considered a single variable factor at a time. The CobbDouglas production function considers two variables factor inputs. The Cobb-Douglas functional form of production function is widely used to represent the relationship of output to inputs. For production the function is Y=ALk Where Y=Output, L=Labour input, K=Capital input A,, =Constant determined by technology.

If + =1 the production function has constant returns to scale. That is if L and K are each increased by 20% Y increases by 20%. If + <1 the returns to scale are decreasing. If + >1 the returns to scale are increasing. Assuming perfect competition a and can be shown to be labours and capitals share of output. The exponents a and are output elasticities with respect to labour and capital respectively. Output elasticity measures the responsiveness of output to a change on labour or capital used in production, other things remaining equal. For example if a=1.5 a 1% increase in labour would lead to approximately a 1.5% increase in output.

Cobb and Douglas were influenced by statistical evidence that appeared to show that the labour and capital share of output were constant over a period time in developed countries they explained this by statistical fitting least squares regression of their production function. Its transformation into linear form by using logarithms is as follows: Log A+Log L+Log K. The common form of Cobb Douglas function used in Macro economic modeling is Y=K L 1- where K is capital and L is labour. When the model coefficient sum to one as above, the production function is first order homogenous, which implies returns to scale that is if all the inputs are doubled the output is doubled. In the Cobb Douglas function, elasticity of substitution between capital and labour that is capital can be interchanged with labour without affecting output.

CES PRODUCTION FUNCTION

Proposed by American economist Kenneth and Arrow CES production function is also known as constant elasticity of substitution production function.This is a linear homogenous production function with constant elasticity of input substitution which takes on the form other than unity. It is replaced the cobb Douglas production function model which looked at physical output as a product of labour and capital inputs The equation for CES production function model is Q=A(aK-b+(1-c)L-b)-1/b Where Q=output ,K=capital ,L=labour a,b,c, are constants

PRODUCTION POSSIBLITY CURVE

An economy has a certain population and some millon workers of various grades, it has mastered certain techniques of production, it has certain resources in the form of land, water and other natural resources.IT has a certain number of inputs. The society has really to decide how this resources can be utilised to produce the various possible commodities. In other words, it has to discover its production possibility curve.

The production possibility curve shows the maximum output of any one commodity that the economy can produce together with the prescribed quantities of other commodities produced and resources utilised.In short PPT curve tells us what assortment of goods and services the economy can produce with the resources and techniques at its disposal. The assortment on the curve is regarded as technologically efficient and below it as inefficient. For the simple reason that the economic is capable of producing a bigger assortment at least in respect of one commodity without decreasing any other. Any assortment which is beyond the frontier is really beyond the economy power and is unattainable. The PPT curve depicts the societys menu of choices.

We shall illustrate the concept of PPT curve by means of table and a daigram. Let us take two commodities X and Y that a firm can produce. If it decides to devote more of its resouces to production X it must sacrifice to that extent production of Y.Take the following tableProduction possibilities X (Thousands) Y (thousands)

A B C D E F

0 1 2 3 4 5

15 14 12 9 5 0

Let all the productive resources available devoted to the production of Y with the result that 15,000 Y but no X in between these two extreme limits there are numerous combinations of X and Y that can be produced .The PPT curve can be depicted by means of diagram given below.In this diagram A represents the one extreme limit at which all ys are produced now if we want to produce some X some Y will have to be sacrifice for instance in order to produce 1000 X we shall have to be content with 14,000 Y instead of 15,000.We have transformed 1000 Y into 1000 X and so on down the table.So, PPT curve is also called as Production transformation curve.

Product Y (Thousands)

In the diagram, the curve marks the production possibility frontier and all points on the curve represent production possibility, the points inside the curve are attainable combinations and those outside such as s, t are unattainable combinations. Any point inside the curve represents an under utilisation of resources or under-employment. A fuller utilisation will shift the curves outwards. Increase in the resources at the disposal of the firm will take it to higher
production possibility curve.

MARGINAL RATE OF TRANSFORMATION We have seen above that in order to produce more X we must sacrifice some Y,that is Y can be transformed into X,the rate at which one products is transformed into another is called as marginal rate of transformation for instance marginal rate of transformation between good X and good Y is the amount of Y which has to be sacrificed for the production of X .This makes PPC concave in the origin.The MRT at any point on production possibility curve is given by slope of the curve at that point.

ECONOMIC REGION PRODUCTION (RIDGE LINES)

Generally production functions generate isoquants which are convex and negatively sloped, do not intersect each other and higher the isoquants greater the level output. There are some production functions which yield isoquants having all the properties except they are not negatively sloped segments. In other words they are positively sloped segments

CAPITAL

LABOUR

Let us consider isoquant P3. AB segment of this isoquant is positively sloped. Similarly other isoquants have the slope. Beyond points A and B this isoquant is positively sloped. The points where they bent back upon themselves implying that they become positively sloped. The lines OK and OL joining these points are called ridge lines. They form the boundaries for the economic region of production.

Suppose the output represented by isoquant P3 is to be produced. For producing this quantity a minimum of OK2 amount of capital is required because any smaller amount will not allow the producer to attain the P3 level of output. With OK2 amount OL2 amount of labour must be employed.In case the producer uses an amount of labour less than OL2 together with OK2 amount of capital his output level would be lower than the one represented by isoquant P3.This is quite normal because smaller inputs would lead to smaller output.But combining labour input in an amount larger than OL2 with OK2 amount of capital would also result in output smaller than represented by isoquant P3.In oder to maintain P3 level output with a larger amount has to be used. This is something no rational producer would attempt to do because it involves uneconomic use of resources.

Point B on isoquant P3 represents the intensive margin of labour because an increase in the labour input beyond OL2 with fixed amount of capital input OK2 results in a fall of in the output level. AT this point marginal product of labour is zero and thus the MRTS of labour for capital is zero. This implies that at point B labour has been substituted for capital to the maximum extent.

Similarly for producing P3 level of output a minimum of OL1 amount labour input in required. A smaller amount of labour input will not the producer to attain P3 level of output. With OL amount OK1 amount of capital must be used and any additions to capital input beyond OK1 would result in smaller output. Therefore the marginal product of capital is zero at point A. This point represents intensive margin of capital because increase in the amount of capital input beyond OK1 with a fixed labour input of OL1will reduce rather than augment output. At point A on P3 capital has been substituted for labour to the maximum extent the MRPS of capital for labour is zero which means MRPS of labour for capital infinite

The line OK connects the points of zero marginal product of capital. We have designated it as upper ridge line. Similarly the line OL designated as lower ridge line joins the points of zero marginal product of labour. The combinations of labour and capital inputs comprising the area between ridge lines OL and OK constitute the generalized stage2 of production for both the resources. These combinations that are relevant for production decisions.

Economies of scale

Large scale production is economical in the sense that the cost of production is low. The low cost leads to economies of scale. The economies of scale can be divided into two broad categories as:- a) Internal economies b)External economies. Internal economies are those economies which occur when firms size expand. They emerge within the firm itself as its scale of production increases. Internal economies are the function of the size of firm. External economies are those economies which are shared by all firms in an industry or group when their size expands. They are available to all firms irrespective of their size and scale of production. These economies are the function of the size of the industry or group of industries as whole.

Forms of internal economies

Labour economies. Technical economies a)Economies of superior technique b)Economies of increased dimension. c)Economies of linked process. Managerial economies. Marketing economies. Financial economies Risk minimizing economies a)By diversification of output. b)By diversification market. c)By diversification of sources of supply as well as process of manufacturing.

Forms of external economies

Economies of Economies of technical and Economies of Economies of

localization. information or market intelligence. vertical disintegration. byproducts.

Diseconomies of scale
Difficulties of management. Difficulties of coordination. Difficulties in decision making. Increased risks. Labour diseconomies. Scarcity of factor inputs. Financial difficulties. Marketing difficulties

Economies of scope

The concept of economies of scope is often somewhat used differently than the concept of economies of scope. It refers to reduction in unit cost realised when firm produces two or more products jointly rather than seperately. A multi product firm often experiences economies of scope. These economies exist when a firm produces two products together undser the same production facilities as against producing them under separate facilities. Thus :TC(QX ,QY )<TC(QX, 0)+TC(0 QY )

ILLUSTRATION

A firms total cost function is TC=200-QX QY +QX 2 QY2 Where QX and QY represent the number of units of product x and y. Do economies of scope exist when the firm produces 2 units of x and 4 units of y? TC(QX ,QY )<TC(QX, 0)+TC(0 QY ) TC(QX ,QY ) 200-(2)(4)+(2)2 +(4)2 =200-8+4+16=212 TC(QX ,0)=200 Qx (0) + QX 2 +(0)2 =200 + QX 2 =200+(2)2 =204 TC(0, QY )=200-(0) QY +(0)2 +(QY )2 =200+ QY 2 =200 +(4)2=216 Since (212)<(204+216) it follows that economies of scope exist.

Degree of economies of scale

The degree of economies of scope can be measured in terms of the difference in the cost of production jointly and separately. The formula is used to measure the degree of economies of scope. DES=TC(An)+TC (Bn)-TC (An+Bn)/TC(An+Bn) Where, DES=degree of economies of scope. TC(An)=Total cost of producing An units of product A separately. TC(Bn)=Total cost of producing Bn Units of products B separately. TC(An+Bn)=Total cost of producing products A and B jointly, that is producing An units of product A and Bn units of product B together.

Learning curve

Experience is the best teacher in business. Over time when the firm accumulates its business experience it may tend to improve its production organization methods with improved knowledge and experience of management and labour used in production process. The firms learning experience would pay in terms of cost of production. In long run these tends to the downward shifts in the average cost curve of the firm on account of learning experience effect that improves productive efficiency of the firm in its operations over a time. Learning effect is different from scale economy effect. It is the difference between actual average cost and estimatede average cost. It implies saving in cost .

Economies of scale are measured through a give LAC as a change in the level of output per time period. The learning effect rate can be measured by using a formula:LER=[1-ACt1 /ACt0 ]*100 Where , LER=learning effect rate. ACt0 =average cost in initial period (t0) increment. ACt1 =average cost in next period(t1) increment. Incidentally the ratio ACt1 / ACt0 is referred to as experience factor.

X efficiency

Cost economy is the major goal of a business firm. Efficiency in production implies cost economy. An efficient firm will tend to experience lower cost function. When the efficiency improves cost function of the firm tends to shift downwards. In practice a major way of cost reduction is seen through minimization of the wastage of resources. More wastage implies higher cost. Low wastage means low cost. X efficiency is a function of management to reduce and minimize the waste of resources in operations. New approaches such as Six Sigma methodology are essentially meant towards attainment of X efficiency (waste minimization as well as zero defect level) of business firm.