Laws of Production

The PF has been explained by different economists in different ways to formulate laws relating to the relationship between inputs and outputs. They are: 1. First Type of PF has only one factor variable while other factors are kept constant. Prof Benham explained this type of PF which has been described as The Law Of Variable Proportions. Modern version of the law of diminishing returns. 2. Second Type of PF with Two Variable Inputs and all other factors kept constant. Iso- Quants and Iso

-Costs
3. Third type of PF , the quantities of every input in the combination of inputs can be varied to produce different quantities of OP. Known as The

TOTAL PRODUCT (TP )

= Total # of unit produced per unit of time by all the factor inputs In SR Total OP increases with an increase in the variable factor input. Thus TP= f(QVF) where QVF denotes the quantity of the variable factor.

Measurements of Product

AVERAGE PRODUCT (AP)

= The total product per unit of a given variable factor . AP= TP/QVF Ex: TP of a commodity is 400 units per day with 25 workers then, AP= 400/25= 16 units per worker.

MARGINAL PRODUCT (MP) = owing to the addition of a MP= TP

unit to a variable factor , all other factors being held constant , the addition realized in the total product is technically referred QVF to a the MP. MPn = TPn TPn-1 where

MPn = MP when n units of a variable factor are employed. TP = Total Product and refers to the # of units of variable factor employed (n= QVF).

The Law of Variable Proportions Only one factor of Production is variable while other

factors are fixed. As we Increase the quantity of variable factor while keeping other factors constant the OP of variable factor may increase more than proportionately in the initial stages of Production but finally it will not increase proportionately.

As the proportion of one factor in a combination of factors is increased after a point, the average and marginal production of that factor will diminish. Conditions underlying the law are as follows:
Only one factor is varied and all others should remain constant. The scale of OP is unchanged, and the Production plant or the size efficiency of the firm remain constant The technique of P does not change. All units of the factor input varied are homogenous,

short run, as the amount of variable factors increases, other things remaining equal, OP(or the returns to the factors varied will increase more than proportionally to the a amount of the variable inputs in the beginning than it may increase in the same proportion and ultimately it will increase less proportionately. Assuming that the firm only varies the labour (L), it alters the proportion between the fixed input and the variable input. As this altering goes on, the firm

The Law of Variable Proportions : In the Elaborately stating the Law

Using the concept of MP, During the SR, under the given state of technology and other conditions remaining unchanged, with the given fixed factors, when the units of a variable factor are increased in the production function in order to increase the TP, the TP initially may rise at an increasing rate and after a point, it tends to increase at a

Units of Total Average Variable Product Product Input (TP) (AP) (Labour) (TPn) (n) 1 2 3 4 5 6 7 8 9 10 20 50 90 120 135 144 147 148 148 145 20 25 30 30 27 24 21 18.5 16.4 14.5

Production Schedule

Marginal Product (TPn- TPn-1)

20 30 40 30 15 9 3 1 0 -3 STAGE III STAGE II STAGE I

ng ishi iminturns D e
R
g sin a cre urns In et R

Ne g Re ativ tur e ns

T P

Stages
Diminishing Total returns -implies reduction in total product with every additional unit of input. Diminishing Average returns -which refers to the portion of the Average Physical Product curve after its intersection with MPP curve. Diminishing Marginal returns refers to the point where the MPP curve starts to slope down and travels all the way down to the x-axis and beyond. Putting it in a chronological order, at first the marginal returns start to diminish, then

Observations
The L of DMR becomes evident in the marginal product column. Initially MP of Labor rises . The TP rises at an increasing rate (= MP). Average Product also rises. Stage of increasing Returns After certain point (4th unit of Labour), the MP begins to diminish. Rate of increase in the TP slows down. Stage of diminishing returns. When AP is max, AP=MP=30 at 4th unit of labour. AS MP diminishes, it becomes zero and negative thereafter (Stage III) When MP is zero, TP is maximum. (148 is the highest amount of TP, when MP is equal to 0 when 9 units of

PF Through Iso quant Curve

Equal Product Curve (Iso-Quant - meaning equal quantity) or also called as Production Iso- Quant. The firm increases its OP by using more of two inputs that are substitutes for each other say, Labour and Capital The two variable input case may be a short run or a long run based on the assumptions made Firm uses only twin inputs and both of them are variable long run analysis If more than two inputs are used but only two of them are variable and others fixed then short run analysis

Iso quant Curve

It represents all the combinations of two factor inputs which produce a given quantity of product.

Ex:

2L+9K 3L+6k 4L+4k 5L+8k

EPC signifies a definite measureable quantity of OP so the units of OP can be labeled to the given iso-quant. Iso quant map represents a set of iso-quants describing production function of a firm. A higher IQ represents a larger quantity of OP than the lower one.

Equal Product Combination

Combinations A B C D E Factor X Labour Factor Y Capital 12 8 5 3 2 1 2 3 4 5 Total OP in Units 100 100 100 100 100

Production Function Plot

Q AN U TITY

4 0 3 0 0 Q AN U TITY 2 1 0 0 0 1 2 3 0 4 5 6 LABO R
07/21/12

3 -4 0 0 2 -3 0 0 1 -2 0 0 0 0 -1 6 3 CAPITAL

12

An isoquant is a contour, which contains all input combinations yielding the same production output
6 5 4 3CAPITAL 2 1 0
07/21/12

Isoquants

Q AN U TITY 3 -4 0 0 2 -3 0 0 1 -2 0 0 0 0 -1

3 LABO R

0 6
13

Properties of Iso-Quant
Iso- Quants have negative slope. Are convex to Origin Do not intersect and do not intercept either axis. Are oval in shape

 IC indicate higher level of satisfaction. EPC indicate the quantity of OP. IC relate to combinations of 2 commodities. EPC relate to combinations between two factors of production. Cant be labeled but EPC can be labeled numerically as physical units of OP. On Ic, between higher and lower IC, the extent of difference in the satisfaction is not quantifiable. In EPC, the size of the physica OP at various points on EPM are

Difference between EPC and IC

Marginal Rate of Substitution

Marginal Rate of Substitution (MRS) is the rate at which one input can be substituted for another without changing the production output. MRTS will be diminishing and hence is known as the law of Diminishing Marginal Rate of Technical Substitution (DMRTS). X Factor Y Combination Feactor MRTS of X
s Labour Capital 1 2 3 4 5 for Y Nil 4:1 3:1 2:1 1:1 A B C D E 12 8 5 3 2

Marginal Rate of Substitution

The MRS is related to the slope of the isoquant at any combination of inputs
6 5 CAPITAL 4 3 K 2 1 0 1 2 3 4 5 6 LABO R L INCREASED QUANTITY

MRS KforL

dL L = (1) = ( 1) dK K

L L1 L2 MRSKforL = (1) = K K 2 K1
The MRS is the negative of the slope of the isoquant

Isocost Lines
PK = $1/unit K PL = $2/unit L

An isocost line is a line containing all input combinations that result in the= P ( K ) cost. ) CO same + PL ( L K The cost With constant cost: equation is:
PK 1 L = = PL 2 K

3 .5 3 In u L (u its) pt n 2 .5 2 1 .5 1 0 .5 0 0 1 2 3 4 5 6 Input K (units)

INCREASED COST
t os C = $6

 What is least-cost production and how is it measured and achieved? Least Cost Production occurs when the inputs are combined in such a way that the cost is minimum. NOTE: Unit cost of Marginal Product tells how output varies much output we get from an inversely with input productivity. additional unit of input. Q Q Q Q MPL = product Greater marginal L = L2 L1 MPL = L or means lower cost per2 1 additional unit of output.
19

Least-Cost Production

MRS related to Marginal Product

If we move along an isoquant (Q is constant) then the impact of increasing one input must be offset MPL input. by= the decrease in the other( L) = MPK ( K ) Q = 0 M P ( L) + M P ( K ) L K therefore: The rate at which one Or input can be substituted
MPK L = = MRS LforK MPL K

for another is inversely related to their productivities

20

 The optimal combination of factor inputs may help in either minimizing cost for a given level of OP or maximizing OP with a given amount of investment expenditure. For every production output quantity there is a unique combination of inputs that minimizes cost called the Least-Cost Combination of Inputs. Integration of the Iso-quant curve with that of the Iso cost line represents the position of equilibrium where the Iso cost line is tangential to the Iso quant curve. Represents minimum cost or optimum factor combination for producing a given level of OP here MRTS between two points is equal to the ration between the process of the inputs.

Producers Equilibrium -Optimum factor combination or least cost combination

Test for Least-Cost Combination

With constant cost:
In u L (u its) pt n 6 5 4 3 2 1 0 0 1 2 3 4 5 6 In u K(u it pt n s) Increase cost until the curves first touch this is the least-cost combination

PK L = PL K

With constant quantity:

MPK L = MPL K

Therefore at the leastcost combination:

07/21/12

MPK MPL = PK PL

22

Expansion Path
Given the slope of the isocost line (input price ratio), each isoquant has a unique least-cost combination A least-cost point occurs whenever an point.
isocost line is tangent to an isoquant. These points can be connected to form an expansion path. In the long run, the firm will expand by moving out the path that connects these points.

07/21/12

23

Economic region
The economic region of the isoquant is determined by drawing tangents to the curves parallel to the axes, and the points of tangency indicate zero marginal productivity of the abundant factors. Ridge lines are lines which connect all the points where MPK and MPL are zero. The region between the ridge lines is called the economic region of production. In the long run, a profit oriented firm will never employ input combinations outside the ridge lines.

Ridge Line

Ridge Line

Long Run Production Function Law of Returns to scale

As the firm in the long run increases the quantities of all factors employed, other things being equal, the output may rise initially at a more rapid rate than the rate of increase in inputs, then OP may increase in the same proportion of input and ultimately, OP increases less proportionately. Three phases of Returns in Long Run:
The Law of Increasing Returns The Law of constant Returns The Law of Decreasing Returns

Assumptions: Technique of production is unchanged. All units of factors are homogenous.

Returns to Scale
Units of labour Units if capital % increase in labour and capital Total product % increase Returns to in Total Scale Product

1 2 3 4 5 6 7 8 9

100 200 300 400 500 600 700 800 900

100 50 33.33 25 20 16.66 14.29 12.5

100 220 350 500 625 750 860 940 1000

0 120 59 42.9 25 20 14.66 9.3 6.4

Increasing

Constant

Decreasing

Phases
The Law of Increasing Returns: If PFC (Production Function Coefficient) >1, then increasing returns to scale
Q/Q> F/F= Q / Q X F/ F

where Q/ Q= Proportionate change in OP F/F = Proportionate change in inputs (factors)

Increased returns means increased efficiency of labour and capital in the improved organization with the expanding scale of OP and employment of factor input. Referred to as the economy of organization in the earlier stages of expansion.

The Law of constant Returns

The Law of Constant Returns: The LIR is followed by the constant returns to scale because as the firm continues to expand its scale of operations, it gradually exhausts the economies of scale responsible for the increasing returns to scale. If PFC (Production Function Coefficient) =1, then constant returns to scale. The effect of internal economies emerging in certain factors is neutralized by the internal economies that my result in some other factors, so that the OP increasing in the same proportion as input. CRS are relevant only for the time periods in which the adjustment of all factors is possible.

Q/Q=

F/F=

Q / Q X F/

where Q/ Q= Proportionate change in OP F/F = Proportionate change in inputs (factors)

As the firm Expands , it may encounter growing diseconomies of the factors employed. As such when powerful diseconomies are met by feeble economies of certain factors, decreasing returns to scale set in. There are DRS when the percentage increase in OP is less than the percentage increase in input. Attributed to increased problems of organization and complexities of large scale management which may be physically very difficult to handle. PFC<1, under DRS.
Q/Q< F/F= Q / Q X F/ F where Q/ Q= Proportionate change in OP F/F = Proportionate change in inputs (factors)

The Law of Decreasing Returns

Reasons for DRS

Physical Factors increased proportionately but organizational and management cant be. Business risk increases with the increased scale of production as the entrepreneurial efficiency has its own physical limits. With expansion, growing diseconomies of LS production set in. Increases difficulties of managing a big enterprise.

LARGE SCALE OF PRODUCTION The scale of production means the size of the production unit of a firm or a business establishment. Scale of Production very small to very large depending upon the quantity of OP per unit of time of the firm. Scale varies with size of the firm. With Large scale production require large Input and vice versa.

ECONOMIES OF SCALE AND PRODUCTION

ADVANTAGE Large scale production that result in lower point (average) Costs(cost per unit) AC =TC/Q Economies of scale spread total costs over a greater

Motives Behind Large Scale Production

Desire for Economy

Desire for Large profit

Desire for Economic Power and Prestige Desire for Increase Demand Desire for Self-Defense in competitive Market

DEFINITION
Economies of Scale characterize a production process in which an increase in the scale of the firm causes a decrease in the long run average cost of each unit. it is measure in Money terms. Classification Internal Economies: Economies which are open to an individual firm when its size expands. The cost per unit depend s on the size of the individual firm. External Economies: Economies which are shared by all the firms in an industry or in a group of industries when their size expands. The cost per unit depends on the

Size of the Firm and Industry

Size of a firm is measured by the value of its output or by the number of laborers it employs, or by the amount and value of its fixed capital such as buildings, plant and equipment. The size of an industry depends on the size of firms it constitutes and their number. Industry consists of large and small firms. Thus, the size of an industry increases when: There is an increase in the number of firms in it or There is an increase in the size of firms comprising it.

FORMS OF INTERNAL ECONOMIES Labour Economies

Technical Economies Economies of Superior Technique Economies of Increased Dimension Economies of Linked Process Economies in Power Economies of By-product Economies of Continuation Managerial Economies Marketing Economies Financial Economies Economies of vertical Integration Over Head Economies Transport and Storage Economies Risk-Minimising Economies By diversification of OP By Diversification of Market

FORMS OF EXTERNAL ECONOMIES

Economies of localization Economies of Information or Technical and Market Intelligence Economies of Vertical Disintegration Economies of By-product

 Increased division of labour.

LABOUR ECONOMIES

Increase output and grow labour force. Attract more efficient labour and offer wide vertical mobility and specialisation. Better prospects of promotion. Efficiency and productivity of labour increased. It also reduces the cost per unit of

Definition: Technical economies refer to reductions in the cost of the manufacturing process it self. These relates to methods and techniques of production, especially to the nature and forms of capital employed .
Types of Technical economies

TECHNICAL ECONOMIES

1. Economies of Superior Technique 2. Economies of Increased Dimension 3. Economies of Linked Process 4. Economies in Power 5. Economies of By-product 6. Economies of Continuation 7. Inventory Economies

Economies of Superior Technique: As a firm expends, it can use superior techniques and capital goods. A small firm cannot install a high quality machine or other capital goods which a big firm can use. Ex: In textile industry for instance an automatic loom is more economical than handloom.

Economies of Linked Process It is the arranging production activities in a continuous sequence with out any loss time. It is the time saving and transport cost saving. It means production cost decrease. For example the same reason process of editing and printing of News papers are generally carried out in same premises.

Example of the economies of linked process

In the iron and steel company :
Melting iron ore Pig iron Mild steel

Rolling steel

Sheet plate

Etc.

These are linked together to avoid waste of power, heating process and, thus to achieve

Economics in Power
Large unit of machines and their running by a large firm are often more economical in their power consumption as compared to small machine.

Economies of Increased Dimension

Large pieces of equipment are relatively more economical than smaller ones and usually there is an optimal minimum to the size any piece of equipment. The reason for this lies in the laws of physical universe which govern the rate of increase of the various properties of inanimate bodies with an increase in their size. Ex :- A double-decker bus is more economical than a single decker-bus.

Economies of By-products:
Large firms can make a more economical use of their raw materials, which it can economically use for manufacturing certain by-products. Large chemical companies are for instance constantly developing new varieties of by-products like cane pulp and molasses of sugar

Economies of Continuation: Technical economy is also realized due to long run continuation of the process of production. Example: In the printing press industry ,there is an apparent economy to be realized by printing more copies of a composed sheet . Thus, if composing and printing cost of 1000 copies per page is Rs .12 for 2000 copies it would cost only Rs.14 that is just Rs. 2 more for the extra 1000 copies, because the same sheet plate which is composed once will remain in use for printing extra copies. Hence, there is only additional printing cost involved while the composing cost remains the same. Inventory Economies: A part of materials management Example: Just-In-Time or Zero level inventory techniques. Rationale is to ask the seller of the inputs to supply them just before the commencement of work in the production department each day instead of having huge stocks worth of lakhs.

Delegation of details Functional Specialization

Managerial Economies

As a result of the indivisibility of managerial factors, the cost per unit of management will fall as OP increases, thus, with increasing scale of OP, greater managerial economies are enjoyed by an expanding firm. Good manager can organize a large OP with the same efficiency as he can organize a small OP. Remuneration same whether OP is small or large. Delegation of work to his trained and specialized personnel in his various departments results in efficient productive management with scientific business administration.

MARKETING OR COMMERCIAL ECONOMIES

Marketing economies are the economies of buying of raw materials and selling goods produced. Large farm can buy more cheaply
By paying wholesale price -Bulk buying By employing purchasing expertsSpecialist buyers Branding Specialist transport

FINANCIAL ECONOMIES
Large firms have a wider reputation and greater influence in the money market. Large firms would be able to
negotiate cheaper finance deals. be more flexible about finance share options , right issues, etc. utilize skills of merchant banks to arrange finance borrow money at lower rates of interests than smaller firms. raise capital easily by issuing shares and debentures. have a ready market for its shares.

Economies of vertical Integration Benefits increase when integration of a number of stages of production is achieved. Flow of goods is more readily controlled leading to controlled costs(reduction in costs) Over Head Economies On account of large scale operations expenses on establishment, administration, book-keeping are more or less same. Hence cost per unit is low. Transport and Storage Economies Arise on the account of the provision of better, highly organized and cheap transport and storage facilitates and their complete utilization. Can own fleet of vehicles. Can have own storage facilities.

Risk-Minimizing Economies
A large firm by producing a wide range of products is in a position to eliminate or minimize business risks by spreading them over in the following ways: By Diversification
of OP of Market of sources of Supply as well as Process of manufacturing

Economies of Localization:

External Economies

When a number of firms are located in one pace, all of them derive mutual advantages through the training of skilled labour, provision of better transport facilities, stimulation of improvements, etc. Concentration of a particular industry in one area, results in the development of conditions helpful to the industry. All firms reap mutual benefits.

Economies of Information or Technical and Market Intelligence

Large and growing industry can bring out trade and technical publications to which every firm can have the access Each firm can enjoy the benefit of the research work. Can save from independent research work or data collection. Statistical, future trends, technical and other market information is available to all firms in a growing industry. As a result cost of production decreases.

Economies of Vertical Disintegration: When a particular process in a industry is split up and performed on a large scale by a specialized firm, then its calls vertical disintegration. New subsidiary industries grow to serve the main industry which results in lower cost. Economies of By-product: A number of Industries can use the waste material produced in their factory to manufacture By-products. The firm using it can flourish when waste material available in it is converted in to by-products. Industry also can sell these waste material to other industries which use it as raw material & can gain profit. This means an indirect economy in cost.

DISECONOMIES OF SCALE
Definition:
A diseconomy of scale is the opposite of an economy of scale. If some cost of a business rises with an increase in size, by a greater proportion than the increase in size, it is a diseconomy of scale.

Factor of Diseconomies
Difficulties of Management Difficulties of coordination Difficulties of Decision Making Increased Risks Labour Diseconomies Scarcity of Factor Supplies Financial Difficulties Marketing Diseconomies

Difficulties of Management
As the firm develops, the problems for management also increases . After a certain point, the manager himself finds difficult to control the whole organization. The entrepreneur and the manager cant maintain a good rapport with all the departments of large concern. The problem of supervision becomes rather difficult and intractable. This leads to increasing possibilities of mistakes and mismanagement

07/21/12

Difficulties of Coordination
With the increase in the size of the organization, the tasks progressively becomes more and more difficult. This creates a problematic situation in decision making and organizing. This may leads to disturb the individual time allotment to clear the problems. Decisions taken in hurry may leads to inefficiency and increase in cost of goods.

Difficulties in Decision Making

A large firm cant take quick changes and decisions when they are needed, it has to share with all the departments to take, and this needs a required timely decisions are inevitably delayed. This may leads some loss to firm.

07/21/12

INCREASED RISK
As a scale of production increase, investment also increase, so too the risk of business. The larger output, obviously the greater will be the loss. It is the important limitation to increase the size of the firm.

LABOR DISECONOMICS

Extreme division of labor with a growing scale of output result in lack of initiative and drive in a executive personnel. Thus the firm become more impersonal and contact between management and worker become less, which result into industrial dispute, which prove to be costly to the large firm.

SCARCITY OF FACTOR SUPPLIES: Due to the increase in the concentration of firms in a particular locality, each firm will find scarcity of available factors. Hence competition among firms in purchasing labor, raw materials etc. will result in increased factor prices. Thus, extreme concentration of external economies becomes a sort of diseconomy in the form of high factor prices. FINANCIAL DIFFICULTIES A big concern needs huge capital which cannot always be easily obtainable. Hence the difficulty in obtaining sufficient capital frequently prevents the further expansion of such firms. MARKETING DISECONOMIES When the industry expands and the firm grows, competition in the market tends to become stiff. Thus, firms under monopolistic competition will have to undertake extensive advertising and sales promotion efforts and expenditure which ultimately lead to higher costs.

Economies of Scope
It refers to the reduction in unit cost realized when the firm produces two or more products jointly rather then separately. A multi product firm often experiences economies of scope leading to the lowering to the cost. It exist when a firm produces two or more products together under the same production facilities as against producing them under separate facilities. It reflects in the lesser cost or cost economy. Example- Onida to produce TV set and DVD player utilizing single assemble plant to produce these good at two separate ,less intensively used plants It may be prove to be less expensive or more economical It is realized by avoiding duplication of the factor inputs in certain ways under a joint operation as compared to

DEGREE OF ECONOMIES OF SCOPE(DES):

o It can be measured in terms of the difference in the costs of production jointly and separately. o The formula used to measure the degree of economies of scope is 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 product B separately TC(An+Bn)=total cost of producing products

 Positive value of DES indicates existence of economies of scope. Negative value of DES implies diseconomies of scope. Negative DES suggests that it is more economical to produce two goods separately than jointly.