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					ENGINEERING ECONOMICS
FINANCIAL ANALYSIS




III/IV – Open Elective
                    UNIT - II
• Theory of Production & Cost Analysis: Production
  Function – Isoquants and Isocosts, MRTS, Least Cost
  combination of inputs, Laws of Returns, Internal and
  End economics of Scale.

• Cost Analysis: Cost Concepts, Opportunity Cost,
  Fixed vs. Variable Costs, Explicit vs. Implicit Costs,
  Out of Pocket vs. Imputed Costs, Break Even
  Analysys (BEA) – Determination of Break Even Point
  (Simple Problems) – Managerial Significance and
  Limitations of BEA
INTRODUCTION

 In economics, the term production means
  process by which a commodity (or
  commodities) is transformed into a
  different usable commodity.

 In other words, production means
  transforming inputs (Labour, Machines,
  Raw Materials etc.) into an output.

 This kind of production is called as
  manufacturing.
INTRODUCTION (CONTD…)
 The production process however does not necessarily
  involve physical conversion or raw materials into
  tangible goods.
 It also includes the conversion of intangible inputs
  into intangible output.
 For example, production of legal, medical, social and
  consultancy services where lawyers, doctors, social
  workers and consultants are all engaged in producing
  intangible goods.
 An input is a good or service that goes into process of
  production and output is any good or service that
  comes out of production process.
PRODUCTION
 In general, production means “Any activity of making
  something material”.

 In Economics, Production means, “Any Economic
  Activity which is directed to the satisfaction of wants
  of the people.

 Production means “Creation or addition of utility”
PRODUCTION
PRODUCTION
 Form Utility:
   Changing the form of natural resources i.e.
    converting the raw materials into items processing
    utility.

   For example, changing the form of a log of wood
    into a table or changing the form of iron into a
    machine.
PRODUCTION
 Place Utility:
   Changing the place of resources from the place
    where they are of little or no use to another place
    where they are of greater use.

                      • Removal of Coal, Gold and etc. from
   Extraction from      mines and supplying them to the
        Earth           markets.

   Transferring of    • Removal of Coal, Gold and etc. from
   goods from one       mines and supplying them to the
                        markets.
   place to another
PRODUCTION
 Time Utility:
   Making available of materials at times when they
    are not normally available.

   For example, harvested food grains are stored for
    use until next harvest.
   Canning of seasonal fruits is done to make them
    available during offseason.
PRODUCTION
FACTORS OF PRODUCTION


NATURAL         HUMAN
RESOURCES       RESOURCES
                • Labour
• Land          • Entrepreneur
                • Capital
LAND
 Land in economics does not mean soil or earth’s
  surface alone.
 It refers to all free gifts of nature which would include
  natural resources, fertility of soil water, air etc.
 Characteristics:
    It is a free gift of nature, strictly limited in quantity.
    It cannot be shifted from one place to another.
    Properties of land cannot be destroyed.
    Land does not yield any result unless human efforts are
     employed.
LABOUR
 Labour is referred to as “Mental or Physical exertion
  directed to produce Goods or Services”.
 Work done for the sake of pleasure or love does not
  represent labour in economics.
 Characteristics:
   Directly connected with human efforts.
   Highly perishable
      A labourer cannot store his labour.
   Inseparable from labourer.
   Labour power differs from labourer to labourer.
   All labour is not productive.
CAPITAL
 Capital is that part of wealth of an individual or
  community which is used for further production of
  wealth.
 It is a stock concept which yields a periodical income
  which is a flow concept.
 It is termed as “Produced means of Production” or
  “Man Made instruments of Production”
 It means sustained increase in the stock of real
  capital in a country. Also called as investment.
 Stages of capital formation are:
    Savings, Investment and Mobilization of Savings
ENTREPRENEUR
 Entrepreneur mobilizes all the factors of production
  i.e. Land, Labour and Capital, combined in right
  proportion, initiates the process of production and
  bears risks involved in it.
 Also known as “Organizer”, “Manager” and “Risk
  Taker”.
 Functions of Entrepreneur:
   Initiating a business enterprise and resource coordination.
   Risk bearing or uncertainty bearing.
      Financial Risk
      Technological Risk
    Innovations
FIXED   AND   VARIABLE INPUTS
 In economic sense, a fixed input is one whose supply
  is inelastic in the short run .
 Therefore all of its users cannot buy more of it and
  cannot employ more of it in the short run.
 If one buys more of it, some others will get less of it.

 A variable input is defined as one whose supply in the
  short run is elastic.
 All users of such factors can employ larger quantity
  in short run.
FIXED   AND   VARIABLE INPUTS (CONTD…)
 In technical sense, a fixed input remains constant up
  to a certain level of output where as a variable input
  changes with change in output.

 A firm has two types of production functions

   1. Short Run Production Function

   2. Long Run Production Function
PRODUCTION FUNCTION
 Production function shows technological relationship
  between quantity of output and quantity of various
  inputs used in production.
 Production function in economic sense states the
  maximum output that can be produced during a
  period with certain quantity of various inputs in the
  existing state of technology.
 It is the tool of analysis which is used to explain input
  – output relationships.
 In general it tells that production of a commodity
  depends on specified inputs.
SHORT RUN & LONG RUN FUNCTIONS

 Short run refers to a period of time in which the
  organization can alter manufacturing by changing
  variable factors such as supplies and labour but
  cannot change fixed factors such as capital.

 Long run refers to a period of time adequately long
  enough so that all factors together with capital can be
  altered.
SHORT RUN PRODUCTION FUNCTION
 Factors which can be increased in short run are
  called as variable factors as they can be easily
  changed in a short period of time.
 This level of production can be increased within the
  limits of the existing plant capacity.
 Short run production function proves that in short
  run output can be increased by changing the variable
  factors, keeping the fixed factors constant.
 Behavior of production in short run where output is
  increased by increasing one variable factor keeping
  other factors fixed is called as law of variable
  proportions.
LONG RUN PRODUCTION FUNCTION
 Long run refers to a period of time in which supply of
  all the input is elastic, but not enough to permit a
  change in technology.
 In long run, even the availability of fixed factor
  increases.
 Thus in long run, production of commodity can be
  increased by employing more of both variable and
  fixed inputs.
 Size of plant can be varied in the long run and
  therefore, scale of production can be varied in the
  long run.
PRODUCTION FUNCTION (CONTD…)
 Production functions are based on the following
  assumptions:

   Perfect divisibility of both inputs and output.

   Limited substitution of one factor for the others.

   Constant technology.

   Inelastic supply of fixed factors in the short run.
IMPORTANCE      OF   PRODUCTION FUNCTIONS
1. When inputs are specified in physical units,
   production function helps to estimate the level of
   production.
2. It indicates situations where different combinations
   of inputs yield the same level of output.
3. It indicates the manner in which the firm can
   substitute on input for another without altering the
   total output.
4. When price is taken into consideration, the
   production function helps to select the least
   combination of inputs for the desired output.
IMPORTANCE      OF   PRODUCTION FUNCTIONS
5. It considers two types’ input-output relationships
   namely “Law of Variable Propositions” that
   explains the pattern of output in the short-run as
   the units of variable inputs are increased to increase
   the output and “Law of Returns to Scale” that
   explains the pattern of output in the long run as all
   the units of inputs are increased.
6. The production function explains the maximum
   quantity of output, which can be produced, from any
   chosen quantities of various inputs or the minimum
   quantities of various inputs that are required to
   produce a given quantity of output.
LAW OF VARIABLE PROPORTIONS
(LAW OF DIMINISHING RETURNS)
 It states that “if the input of one resource is increased
  by equal increments per unit of time while the inputs
  of other resources are held constant, the total output
  will increase, but beyond some point the resulting
  output increases will be smaller and smaller”.
                                                 By. Leftwich
 It states that “An increase in some input relative to
  other fixed input will in a given state of technology,
  cause total output to increase, but after a point the
  extra output resulting from the same addition of extra
  inputs is likely to become less and less
                                               By: Samuelson
LAW OF VARIABLE PROPORTIONS
LAW OF VARIABLE PROPORTIONS
Total Product (TP):

   Total product is the total output resulting from
    the efforts of all the factors of production
    combined together at any time.

   One factor kept constant, total product will vary
    with the quantity used of the variable factor.

   Total product rises as more and more units of
    variable input is employed.
LAW OF VARIABLE PROPORTIONS
LAW OF VARIABLE PROPORTIONS
LAW OF VARIABLE PROPORTIONS
 Relationship between Average Product and Marginal
  Product:

   MP > AP, when AP rises as a result of an increase
    in quantity of variable input.

   MP = AP, when AP is maximum i.e. MP curve cuts
    the AP curve at its maximum point.

   MP < AP, when AP falls as a result of a decrease in
    quantity of variable input.
LAW OF VARIABLE PROPORTIONS
 Assumptions of Law of Variable Proportions:

  1. The state of technology remains constant. If
     there is any improvement in technology, the
     average and marginal out put will not decrease
     but increase.

  2. Only one factor of input is made variable and
     other factors are kept constant. This law does
     not apply to those cases where the factors must
     be used in rigidly fixed proportions

  3. All units of the variable factors are homogenous.
LAW OF VARIABLE PROPORTIONS
 Variable Factor    Total    Average    Marginal
    (Labour)       Product   Product    Product
       1            100       100      100
       2            210      105.00    110    Stage
       3            330      110.00    120      I
       4            440      115.00    110
       5            520      104.00    80
       6            590       98.33    70
                                              Stage
       7            650       92.85    60
                                                II
       8            700       87.50    50
       9            740       82.22    40
       10           740       74.00     0     Stage
       11           710       71.00    -30     III
LAW OF VARIABLE PROPORTIONS
 Above table reveals that both average product and
  marginal product increase in the beginning and then
  decline.
 Of the two marginal products drops of faster than
  average product.
 Total product is maximum when the 9th worker is
  employed, nothing is produced by the 10th worker and
  its marginal productivity is zero, whereas marginal
  product of 11th worker is ‘-30’.
 11th worker not only fails to make a positive
  contribution but leads to a fall in the total output.
LAW OF VARIABLE PROPORTIONS
LAW OF VARIABLE PROPORTIONS
 From the above graph the law of variable proportions
  operates in three stages.

 In the first stage, total product increases at an
  increasing rate.

 The marginal product in this stage increases at an
  increasing rate resulting in a greater increase in total
  product. The average product also increases.

 This stage continues up to the point where average
  product is equal to marginal product.
LAW OF VARIABLE PROPORTIONS
 The law of diminishing returns starts operating from
  the second stage awards. At the second stage total
  product increases only at a diminishing rate.

 The average product also declines. The second stage
  comes to an end where total product becomes
  maximum and marginal product becomes zero.

 The marginal product becomes negative in the third
  stage. So the total product also declines.

 The average product continues to decline.
ISOQUANTS
 In economics, an isoquant (derived from quantity and
  the Greek word iso, meaning equal) is a contour line
  drawn through the set of points at which the same
  quantity of output is produced while changing the
  quantities of two or more inputs.
 An isoquant shows all those combinations of factors
  which produce the same level of output.
 An isoquant shows the extent to which the firm in
  question has the ability to substitute between the two
  different inputs at will in order to produce the same
  level of output
ISOQUANTS
ISOQUANTS
 Thus an isoquant shows all possible combinations of
  two inputs, which are capable of producing equal or a
  given level of output.

 Since each combination yields same output, the
  producer   becomes   indifferent towards these
  combinations.

 An isoquant is also known as equal product curve or
  iso-product curve.
ASSUMPTIONS OF ISOQUANTS
1. There are only two factors of production, viz. labour
   and capital.

2. The two factors can substitute each other up to
   certain limit

3. The shape of the isoquant depends upon the extent of
   substitutability of the two inputs.

4. The technology is given over a period
EXAMPLE OF ISOQUANTS
Combinations    Labour (units)   Capital (Units)   Output (quintals)
     A                1                10                 50
     B                2                 7                 50
     C                3                 4                 50
     D                4                 4                 50
     E                5                 1                 50
 Combination ‘A’ represent 1 unit of labour and 10 units of
  capital and produces ‘50’ quintals of a product all other
  combinations are assumed to yield the same given output by
  employing any one of the alternative combinations of the two
  factors labour and capital.
 If we plot all these combinations on a paper and join them, we
  will get continues and smooth curve called Iso-product curve as
  shown below.
EXAMPLE OF ISOQUANTS

                   Labour is on the X-
                    axis and capital is
                    on the Y-axis.
                   IQ is ISO-Product
                    curve which shows
                    all the alternative
                    combinations A, B,
                    C, D, E which can
                    produce           fifty
                    quintals of a product
TYPES OF ISOQUANTS
 Isoquants may have various shapes depending on the
  degree of substitutability of factors involved.

  1. Linear Isoquant

  2. Right Angled Isoquant

  3. Kinked Isoquant

  4. Smooth Convex Isoquant
LINEAR ISOQUANT
 In this case, the isoquant would be a straight line.

 This assumes perfect substitutability of factors of
  production.

 In this case, labour and capital are perfect substitutes
  that is the rate at which labour can be substituted for
  capital in production is constant.

 This isoquant evidenced that a given commodity may
  be produced by using only capital or only labour or by
  an infinite combination of labour and capital.
 LINEAR ISOQUANT
 At point A, level of output
  can be produced with
  capital alone (i.e. without
  labour).
 Similarly at point B, the
  same level of output can
  be produced with labour
  alone (i.e. without capital).
 This is unrealistic as
  labour and capital are not
  perfectly substitutable.
RIGHT ANGLED ISOQUANT
 This assumes zero substitutability of factors of
  production.

 There is only one method of producing any one
  commodity.

 In this case the isoquant takes the form of a right
  angle.

 This isoquant is also called as input – output isoquant
  or Leontief isoquant named after Leontief who
  invented input – output analysis.
 RIGHT ANGLED ISOQUANT
 In this case, labour and
  capital     are     perfect
  complements i.e. labour &
  Capital must be used in
  fixed proportion.
 The     output    can    be
  increased      only      by
  increasing     both     the
  quantity of labour and
  capital   in    the   same
  proportion.
KINKED ISOQUANT
 This assumes only limited substitutability of factors of
  production (Capital and Labour).

 There are only a few processes of producing any one
  commodity.

 Substitutability of factors is possible only at the
  kinks.

 This form is also called 'activity analysis-isoquant' or
  'linear-programming isoquant', because it is basically
  used in linear programming.
 KINKED ISOQUANT
 This is more realistic type
  of isoquant as engineers,
  managers and production
  executives consider the
  production process as a
  discrete rather than a
  continuous process.
SMOOTH CONVEX ISOQUANT
 This   type    of   isoquant   assumes    continuous
  substitutability of capital and labour over a certain
  range, beyond which the factors cannot substitute
  each other

 Traditional economic theory has adapted this isoquant
  for analysis since it is uncomplicated.

 This i an approximation to the more realistic form of a
  kinked isoquant because as the number of process
  become infinite, the isoquant becomes a smooth
  curve.
SMOOTH CONVEX ISOQUANT
ASSUMPTIONS OF ISOQUANTS
 Isoquant curves are drawn on the basis of the
  following assumptions:

  1. There are only two inputs , v12 , labor ( L ) and
     capital (K) tom produce a commodity X

  2. The two inputs – L and K – can substitute each
     other but at diminishing rate.

  3. The technology of production is given.
EXAMPLE OF ISOQUANTS
 Points A , B , C and D on the
  isoquant curve IQ1 shows
  four different combinations of
  inputs , K and L , all yielding
  the same output – 100 units .
 The movement from A to B
  indicates decreasing Quantity
  Of K and increasing number
  of L.
 This implies substi- -tution
  Of labor for capital such that
  all the input combinations
  yield the same quantity of
  commodity X i.e.. IQ1 = 100 .
ISOQUANT MAP
 We can label isoquants in physical units of output
  without any difficulty.
 As each isoquant represents a specified level of
  output, it is possible to say by how much the output
  is greater or lesser on one isoquant than on other.
An isoquant map facilitates not
only   measurement     of   physical
quantities of output, but also
compares the size of output between
various isoquants.
Isoquant map contains infinite
number of isoquants.
PROPERTIES OF ISOQUANTS
1. Isoquants slope downwards to the right:
   It means that in order to keep the output constant when the
    amount of one factor is increased, the quantity of other
    factor must be reduced.
2. Isoquants are convex to the origin:
   The slope at any point of an isoquant is negative.
   its numerical value measures the marginal rate of technical
    substitution between labour and capital.
   It equals the ratio of marginal product of labour to the
    marginal product of capital.
PROPERTIES OF ISOQUANTS
3. Isoquants do not intersect:
   By definition, isoquants like indifference curves can never
    cut each other.
   If they cut each other there would be logical contradiction.


4. Isoquants cannot touch either axis:
   If an isoquant touches any axis, it would mean that the
    output can be with the help of one factor.
   It is unrealistic because output cannot be produced only by
    labour or capital alone.
ISOCOSTS
 In economics an isocost line shows all combinations
  of inputs which cost the same total amount.
 Although similar to the budget constraint in consumer
  theory, the use of the isocost line pertains to cost-
  minimization in production, as opposed to utility-
  maximization.
 For the two production inputs labour and capital, with
  fixed unit costs of the inputs, the equation of the
  isocost line is
                             w = wage rate of labour
                             r = rental rate of capital
                             C = total cost of acquiring
ISOCOSTS
 The absolute value of the slope of the isocost line, with
  capital plotted vertically and labour plotted
  horizontally, equals the ratio of unit costs of labour
  and capital.
 The isocost line is combined with the isoquant map to
  determine the optimal production.
 This optimality is arrived at a point where an isoquant
  and isocost curves are tangent to each other.
 It ensures that the firm attains the highest level of
  possible output with a given isocost line.
ISOCOSTS
 The point of tangency between any isoquant and an
  isocost line gives the lowest-cost combination of
  inputs that can produce the level of output associated
  with that isoquant.

 The output is produced with least cost and most
  efficiently.

 The marginal productivities of the two inputs are
  proportional to the ratios of the prices of the two
  inputs.
LEAST COST FACTOR COMBINATION
 Analysis of a production function has shown that
  alternative combinations of factors of production that
  are technically efficient can be used to produce a
  given level of output.
 Of these the firm will have to choose that combination
  of factors which will cost it the least.
 Choice of any particular method from a set of
  technically efficient methods is an economic one and
  it is based on the prices of factors of production at
  that particular time.
 In this way the firm can maximize profits.
LEAST COST FACTOR COMBINATION
 The firm can maximize its profits by maximizing the
  level of output for a given cost or by minimizing the
  cost of producing a given output.
 In both the cases, factors have to be employed in
  optimal combination at which the cost of production
  will be minimum.
 There are two ways to determine the least cost
  combination of factors. They are:
   1. Finding the total cost of factor combinations

  2. Geometrical method
TOTAL COST             OF      FACTOR COMBINATIONS
 Here we try to find out the total cost of each factor
  combination and choose the one which has the least cost.
 Cost of each factor combination is found by multiplying the
  price of each factor by its quantity and then summing it for
  all inputs.
   L        K          Q        Cost of Labour    Cost of Capital    Total
(Units)   (Units)   (Output)   (Rs. 3 per Unit)   (Rs. 4 per Unit)   Cost
  10        45        100            30                 180          210
  20        28        100            60                 112          172
  30        16        100            90                 64           154
  40        12        100            120                48           168
  50        8         100            150                32           182
TOTAL COST         OF   FACTOR COMBINATIONS
 It is clear from the above that 10 units of ‘L’ combined with
  45 units of ‘K’ would cost the producer Rs. 20/-.
 But if 17 units of ‘K’ is reduced and 10 units of ‘L’ is
  increased, the resulting cost would be Rs. 172/-.
 Substituting 10 more units of ‘L’ for 12 units of ‘K’ further
  reduces cost of Rs. 154/-.
 However, it will not be profitable to continue this
  substitution process further at the existing prices since the
  rate of substitution is diminishing rapidly.
 In the above table the least cost combination is 30 units of
  ‘L’ used with 16 units of ‘K’ when the cost would be
  minimum at Rs. 154/-. So this is they stage “the producer
  is in equilibrium”
GEOMETRICAL METHOD
 The second and a more general way to determine the
  least cost combination of factors is done with the help
  of isoquant map and isocost line.

 In order to determine the least cost factor combination
  or the maximum output for a given cost, we have to
  superimpose isoquant map on the isocost line.
GEOMETRICAL METHOD
 Isoquant Map:
   An isoquant map shows all possible combinations of labour
    and capital that can produce different levels of output.
   The isocost line shows various combinations of labour and
    capital that the firm could buy for a given amount of money at
    the given factor prices.


 Slope of an isoquant is
GEOMETRICAL METHOD
 Isoquant Map:
    In the above figure, line AB is the isocost line.
    It shows that the firm can hire OA amount of
     capital or OB amount of labour or some
     combinations of both along the AB line.
    Thus isocost line is the locus of all those
     combinations of labour and capital.
    Slope of isocost line is equal to ratio of factor
     prices.
GEOMETRICAL METHOD
 Slope of Isocost Line:
    Given the monetary resources, if the factor prices
     change the slope of isocost line will change.
GEOMETRICAL METHOD
 Slope of Isocost Line:
    Let us assume that with the given amount of money and the
     prices of labour and capital, the isocost line is AC.
    If the price of labour falls, the firm could hire more than OC
     amount of labour for the same amount of money.
    If we assume that the firm can hire OC1 amount of labour,
     then the slope of the isocost line changes to AC1.
    If the price of labour rises, the firm could hire less than OC
     amount of labour for the same amount of money.
    If we assume that the firm can hire OC2 amount of labour,
     then the slope of the isocost line changes to AC2.
GEOMETRICAL METHOD
 Slope of Isocost Line:
    Isocost line depends up on two factors:
      1. Prices of factors of production
      2. Amount of money which the firm can spend on
         the factors.

    Change in the amount of money will shift the
     isocost lines but the slope remains constant.
    A change in factor prices, for example labour will
     change the slope of isocost lines.
OPTIMAL INPUT COMBINATION               FOR
MINIMIZING COST
 In this case, the firm has to produce the given output
  with minimum cost.




 Isoquant Q denotes the desired level of output to be
  produced.
 There are a family of isocost line AB, A1B1, A2B2.
OPTIMAL INPUT COMBINATION                FOR
MINIMIZING COST
 Isocost lines are parallel because the factor prices are
  assumed to be constant and thus all the isocost lines
  have the same slope.
 The firm minimizes its cost at point e where isoquant
  Q is tangent to isocost line AB.
 Optimal combination of factors is OK and OL.
 Optimal combination takes place at point ‘e’ where the
  given output can be produced at the least cost.
COBB - DOUGLAS PRODUCTION FUNCTION
 Proposed by Knut Wicksell and tested against
  statistical evidence by Charles Cobb and Paul
  Douglas.
 They considered a simplified view of the economy in
  which production output is determined by the
  amount of labour involved and the amount capital
  invested.
 While there are many other factors affecting their
  economic performance, their model proved to be
  remarkably accurate.
COBB - DOUGLAS PRODUCTION FUNCTION
COBB - DOUGLAS PRODUCTION FUNCTION
 Output elasticity measures the responsiveness of
  output to a change in levels of either labour or capital
  used in production with other things the same.
 For example if α = 0.15, a 1% increase in labor would
  lead to approximately a 0.15% increase in output.
 If α + β = 1, the production function has constant returns
  to scale. Doubling capital and labour will also double the
  output.
 If α + β < 1, returns to scale are decreasing and
 If α + β > 1, returns to scale are increasing.
 Assuming perfect competition and α + β = 1, α and β can
  be shown to be labor and capital's share of output
COBB - DOUGLAS PRODUCTION FUNCTION
 Assumptions:
  1. The function assumes that output is the function of
     two factors viz. capital and labour.
  2. It is a linear homogenous production function of the
     first degree
  3. The function assumes that the logarithm of the total
     output of the economy is a linear function of the
     logarithms of the labour force and capital stock.
  4. There are constant returns to scale
  5. All inputs are homogenous
  6. There is perfect competition
  7. There is no change in technology
LAW OF RETURNS TO SCALE
 The law of returns to scale explains the behavior of
  the total output in response to change in the scale of
  the firm, i.e., in response to a simultaneous to
  changes in the scale of the firm, i.e., in response to a
  simultaneous and proportional increase in all the
  inputs.

 More precisely, the Law of returns to scale explains
  how a simultaneous and proportionate increase in all
  the inputs affects the total output at its various levels.
LAW OF RETURNS TO SCALE
 Law of returns of scale explain how a simultaneous
  and proportionate increase in all the inputs affect the
  total output.
 Increase in output may be proportionate, more than
  proportionate or less than proportionate.
 If increase in output is proportionate to the increase
  in input, it is called as constant returns to scale.
 If it is less than proportionate, it is called as
  diminishing returns to scale.
 If it is more than proportionate, it is called as
  increasing returns to scale.
LAW OF RETURNS TO SCALE
 Increasing Returns to Scale:
    If the output of a firm increases more than in proportion to an
     equal percentage increase in all inputs, the production is said
     to exhibit increasing returns to scale.
    Marginal output increases in this stage.
    High degree of specialization, falling cost, etc. will lead to
     higher efficiency which results in increased returns in the
     very first stage of production.
    For example: If the amount of inputs are doubled, the output
     increases by more than double, it is said to be an increasing
     returns to scale.
    When there is an increase in the scale of production, it leads
     to lower average cost per unit produced as the firm enjoys
     economies of scale
LAW OF RETURNS TO SCALE
 Constant Returns to Scale:
   When all inputs are increased by a certain percentage, the
    output increases by the same percentage, the production
    function is said to exhibit constant returns to scale.
   Firms cannot maintain increasing returns to scale after the
    first stage, the firm enters a stage when total output tends to
    increase at a rate which is equal to the rate of increase in
    inputs.
   This stage comes into operation when economies of large scale
    production are neutralized by diseconomies of large scale.
   For example: If a firm doubles its inputs, it doubles its
    output. The constant scale of production has no effect on
    average cost per unit produced.
LAW OF RETURNS TO SCALE
 Diminishing Returns to Scale:
   The term diminishing returns to scale refers to scale where
    output increases in smaller proportion than the increase in all
    the inputs.
   This is because of diseconomies of large scale production.
   When the firm grows further, problem of management arises
    which results in inefficiency and it will affect the position of
    the output.
   For example: If a firm increases inputs by 100% but the
    output increases by less than 100%, the firm is said to exhibit
    decreasing returns to scale.
   The firms scale of production leads to higher average cost per
    unit produced.
LAW OF RETURNS TO SCALE
LAW OF RETURNS TO SCALE
 The above graph shows that when a firm uses one unit of
  labour and one unit of capital, point a, it produces one unit
  of quantity (q = 1).
 When the firm doubles its inputs by using 2 units of labour
  and 2 units of capital, it produces more than the double
  from (q = 1 to q = 3), having increasing returns to scale.
 When the firm doubles its inputs by using 4 units of labour
  and 4 units of capital, it produces double the output from
  (q = 3 to q = 6), having constant returns to scale.
 When the firm doubles its inputs by using 8 units of labour
  and 8 units of capital, it produces half the increase in
  output from (q = 6 to q = 8), showing diminishing returns
  to scale.
ECONOMIES       OF   SCALE    OF   PRODUCTION
 According to Stigler, “Economies of scale is a synonym
  to Returns to scale”.
 When scale of production is increased up to a point,
  one gets economies of scale            and thereafter
  diseconomies of scale will follow.
 Increasing returns to scale is the result of these
  economies.
 Production may be carried on a small scale or o a
  large scale by a firm.
 When a firm expands its size of production by
  increasing all the factors, it secures certain
  advantages known as economies of production.
ECONOMIES   OF   SCALE   OF   PRODUCTION
INTERNAL ECONOMIES OF SCALE
 According to Cairncross, “Internal economies are
  those, which are opened to a single factory or a single
  firm independently of the action of other firms. They
  result from an increase in the scale of output of a firm
  and cannot be achieved unless output increases”.

 Hence internal economies depend solely upon the size
  of the firm and are different for different firms.
CAUSES OF INTERNAL ECONOMIES
 Internal economies are generally caused by two
  factors.
   Indivisibilities:
      Many fixed factors of production are indivisible in the
       sense that they must be used in a fixed minimum size.
      For instance, if a worker works half the time, he may be
       paid half the salary. But he cannot be chopped into half
       and asked to produce half the current output.
      Thus as output increases the indivisible factors which
       were being used below capacity can be utilized to their full
       capacity thereby reducing costs.
      Such indivisibilities arise in the case of labour, machines,
       marketing, finance and research.
CAUSES OF INTERNAL ECONOMIES
  Specialization:
     Division of labour, which leads to specialization, is another
      cause of internal economies.
     Specialization refers to the limitation of activities within a
      particular field of production. Specialization may be in
      labour, capital, machinery and place.
     For example, the production process may be split into four
      departments relation to manufacturing, assembling,
      packing and marketing under the charge of separate
      managers who may work under the overall charge of the
      general manger and coordinate the activities of other
      departments.
     Thus specialization will lead to greater productive
      efficiency and to reduction in costs
CLASSIFICATION     OF INTERNAL      ECONOMIES
 Internal economies of scale are further classified into
  following two categories:

   1. Real Economies and

   2. Pecuniary Economies
REAL ECONOMIES OF SCALE
 Real Economies are those associated with a
  reduction in the physical quantity of inputs such as
  raw materials, various types of labour and various
  types of capital.

 These are mostly associated with indivisibilities of
  units of factors of production.
REAL ECONOMIES OF SCALE
 Real economies of scale are further classified into
  following types:
  1. Labour Economies
  2. Technical Economies
  3. Inventory Economies
  4. Marketing Economies
  5. Managerial Economies
  6. Transport and Storage Economies
LABOUR ECONOMIES
 As the size of the output increases, firm enjoys labour
  economies due to
   a)   Specialization
   b)   Time Saving
   c)   Automation of production process
   d)   New Inventions
 Division of labour condenses the time lost in changing
  from one type of work to another.
 Division of labour promotes invention of tools and
  machines which in turn leads to mechanization of the
  production process.
 This assists the labour in working faster thereby
  increasing the labour productivity.
TECHNICAL ECONOMIES
 These economies influence the size of the firm.
 These result from greater efficiency of capital goods
  employed by the firm.
 Technical economies also arise from indivisibilities
  which are the characteristics of modern techniques of
  production.
 In other words as scale of production increases, the
  firm reaps the advantages of mechanization of using
  mass production methods.
 This will reduce unit cost of production
TECHNICAL ECONOMIES
 These economies are of three types:

      Economies of Increased Dimension

      Economies of Linked Processes

      Economies of use by product
INVENTORY ECONOMIES
 Role of inventories is to aid the firm in meeting
  random changes in the input and output sides of the
  operations of the firm.

 Purpose of inventories is to smooth out the supply of
  inputs and the supply of outputs.

 A large sized firm enjoys several types of inventory
  economies such as:
    Large stock of raw materials
    Large stock of spare parts and small tools
INVENTORY ECONOMIES
 Inventories on spare parts, raw materials and finished
  products increases with the scale of production.

 But they do not increase proportionately with the
  increase in the size of the output.

 Thus as size of the output amplifies, the firm can hold
  smaller percentage of inventories to meet the random
  changes.
MARKETING ECONOMIES
 They are allied with selling of the product of the firm.
 They arise from advertising economies.
 A large sized firm enjoys several types of marketing
  economies such as:
   1. Economies on Account of Advertisement
   2. Appointment of Sole Distributors & Authorized
      Dealers
   3. Economies on Account of Research and
      Development
MARKETING ECONOMIES
 As advertising expenses increase less than
  proportionately with the increase in output,
  advertising costs per unit of output falls as the output
  increases.
 A large firm can also have special arrangement with
  exclusive dealers to maintain a good service
  department for the product of the firm.
 Thus average selling costs fall with the increase in the
  size of the firm.
 All this enables the firms to produce quality products.
MANAGERIAL ECONOMIES
 Large scale production makes possible for the division
  of managerial functions.

 There exists a production manager, sales manager,
  finance manager, personnel manager and so on in a
  large firm.

 In a small firm, single manager takes all those
  managerial decisions.

 Division of managerial functions       increases   the
  efficiency of the managers.
MANAGERIAL ECONOMIES
 Decentralization of managerial decision making also
  increases the efficiency of the management.

 Large firms are also in a position to introduce
  mechanization of managerial functions through use of
  telex machines, computers and so on.

 Thus with increase in production, management cost
  per unit of output goes on falling.
TRANSPORT & STORAGE ECONOMIES
 As output increases, unit cost of transportation of raw
  materials and finished products fall.
 This is because of the following two reasons:
   1. Having an own Transportation system
   2. Having own storage and godown facilities
 This is because the firm may reduce transport costs
  by having their own transportation and also as size of
  the firm increases, storage costs will fall.
 With this the firm is able to sell its products at the
  opportune time and at favourable time.
PECUNIARY ECONOMIES
 These are the economies that are realized from paying
  lower prices for the factors used in production and
  distribution due to bulk buying by the firm as its size
  increases.

 They add to the firm on account of discounts it can
  obtain due to its large scale of production.

 They reduce the money costs of factors for a
  particular firm.
PECUNIARY ECONOMIES
 The pecuniary economies are realized by the firm in
  the following ways:
   1. The firm will be able to get raw materials at lower
      prices due to bulk buying
   2. The firm can get funds at lower costs, i.e. at lower
      rates of interest due to its reputation in the
      money market
   3. The firm may be given lower advertising rates if
      they advertise at large
   4. Transport rates may also be low if the amount of
      commodities transported is large
EXTERNAL ECONOMIES OF SCALE
 External economies of scale refer to all those benefits
  and facilities which are available to all the firms in a
  given industry
 According to Cairncross, “External economies are
  those, which are shares in by a number of firms or
  industries when the scale of production in industry or
  group of industries increases”.
 “They are not monopolized by a single firm when it
  grows in size, but are conferred on it when other firms
  grow larger”.
CLASSIFICATION     OF   EXTERNAL ECONOMIES
 External economies of scale are further classified into
  following two categories:

   1. Economies of Concentration

   2. Economies of Information

   3. Economies of Disintegration
ECONOMIES OF CONCENTRATION
 When several firms of an industry establish
  themselves at one place, then they may enjoy many
  benefits together.

 For example,
    Availability of developed means of communication
     and transportation
    Trained labour by products
    Development of new inventions pertaining to that
     industry etc.
ECONOMIES OF INFORMATION
 When the number of firms in an industry increases,
  then it becomes possible for them to have concerted
  efforts and collective activities.

 These include:
    Publication of scientific and trade journals
    Providing sundry information to the firms of a
     given industry
ECONOMIES OF DISINTEGRATION
 When an industry develops, the firms engages in it
  mutually agree to divide the production process
  among them.
 Every firm specializes in the production of a
  particular item concerning to that industry.

 These are of following two types:
   1. Horizontal Disintegration
   2. Vertical Disintegration
EXAMPLE
• Britain has a history of providing a base for some of
  the most successful teams in Formula One.
• McLaren are based in Woking but Renault, Honda,
  Williams and Red Bull are all clustered in the east
  Midlands.
• Partly this is an accident of history - namely the
  availability of disused airfields after the war.
• But the cluster of F1 teams is also a good example of
  the external economies of scale that can be generated
  when a group of producers develop and expand in a
  relatively small geographical area.
EXAMPLE
 Most of the teams currently racing are based in the
  UK, along with their R&D operations.

 A whole network of industries, such as component
  suppliers, engineering and design firms, have sprung
  up in Britain, mostly in central England, to serve the
  sport both here and abroad.

 F1 also helps to support a far larger motorsport
  industry in the UK, for example rally car racing and
  all its associated industries

				
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