Production 7 mf Learning Objectives a ns 6.1 The Production Function 6.2 Production in the Short-Run 6.2.1 Production with One Variable Input (Labour) 622 Relationship between TP,, MP, and AP, Curves 6.3 Law of Variable Proportions 6.3.1 Statement of the Law 6.3.2 Assumptions of the Law 6.3.3. Stages of Production 6.4 Production in the Long-Run 6.4.1 Production with Two Variable Inputs—the Concept of Isoquants 6.4.2 Features of Isoquants 6.5 Isocost Line 6.6 Producer's Equilibrium or Optimal Constraint Case 1: Maximise Output Subject to a Cost Constraint Case 2: Minimise Cost Subject to an Output Constraint 6.7 Expansion Path 6.7.1 Long-Run and Short-Run Expansion Paths 6.7.2 Linearly Homogeneous Production Function 6.8 Exceptions to the Convex Shape of an Isoquant Curve 6.8.1 Elasticity of Substitution Between Two Factors 6.8.2 Labour and Capital are Perfect Substitutes 6.8.3 Labour and Capital are Perfect Complements 6.9 Returns to Scale 6.9.1 Increasing Returns to Scale 6.9.2 Constant Returns to Scale 6.9.3 Decreasing Returns to Scale 6.10 Reasons behind Returns to Scale—Economies and Diseconomies of Scale 6.10.1 Economies of ScaleBusiness Economics TRetums to Factor vs. Retums to Scale 6.12 Solved Illustrations + Points to Remember + Review Questions 6.1 THE PRODUCTION FUNCTION The theories of production and cost are essential for understanding how conomic scarcity gets translated into prices in the market place. The roots ‘of both these theories lie in the concept of a production function, Production is a process by which goods and services are made available to the consumer ‘he term production process simply means the physical relationship between inputs used and the resulting output or conversion of inputs! (or factors Sif production) into outputs. The ferm production function is a purely ‘cknical relation which connects the quantity of inputs required to prroduce maximum output. Thus, the production function is the process lof getting the maximum output from a given quantity of inputs in a particular time period. Both inputs and outputs are flows. It includes ‘nly technically efficient combinations of inputs (i.e., those which minimise the cost of production). The general produetion function is expressed as X=f(L,K,R,E,V, 5) where X = Level of output which is a function of the inputs L® Labour K = Capital R= Raw materials E = Efficiency V = Retums to scale S= land * Assuming that production process requires only labour and capital to Production produce’ output, the production function ean be then expressed as X =f (L, K), ceteris paribus ‘The equation relates the quantity of output (X) to two inputs (L and X) Example of production function can be production of wheat by using. apecific amount of workers and machines. 6.2 PRODUCTION IN THE SHORT-RUN Economists make a distinction between two types of time periods—short- run and long-run. According to Samuelson, short-run is a period in which firms can adjust production by changing variable factors such as materials and labour but cannot change quantities of one or more fixed factors Such as capital, land etc. The long-run is-a period long enough to permit changes in all the factors of production. The actual length of the short- run cannot be told. It can vary from 1 hour to 10 days to 10 years to Centuries depending upon the time taken by the fixed factor to become Variable in supply. in the short-run, the production can be changed by changing variable inputs since the quantity of fixed input cannot be ‘varied. Since capital is generally fixed in the short-run, it is expressed as K , where the bar indicates that capital is fixed in amount. Thus, the short-run production function is of the type: x=fRD) Example of a short-run produgin function: Production of Dread is a function of fixed amount of equipment and variable amount of labour red 6.2.1 Production with One Variable Input (Labour) at us take short-run production function as: X= f (Land, Labou) Total Product (TP,) ‘TP is defined as the total quantity of goods————EE~~EoOEO 64 Business Economics Production the firm in its decision making, process as it tells the firm how much be the addition in output by adding one more unit of labour. ‘The MP, can be written as = ap, = henge in Teel Ou pu Change in Labour Input oe TP, ‘aL (MP, ean be calculated from the values of TP, by the formula : MP, for n® unit = where n= Number of labour units, Mlustration. Ih the shortrun production function X = f (L,R), capital input is assumed to be constant. What will be the affect on MP of labour if capital input is. increased? Solution. ‘MP, will increase if capital input is increased becnuse additional labourer Mill be more productive if they have more machines equipments to use. ‘Average Product of Labour (AP,) {AP, measures the productivity of the firm’s labour in terme of how mut ‘output each labour rmadiices on average. AP, is defined as the amount of output per unit of the variable factor employed, it Total output | aaa) | | from the origin to that point fon the TP, curve. The val peter eared pee eget TP valve of slope AP, curve initially rises, reaches a maximum and then falls. jonship between TP,, MP, and AP, Curves derived from the TP, curve as graphically I he slope of te TP, curve a se TP, curve isthe so the TP, curve! The slope rises up int that point slope \ when the slope of the tangent MAARR t BADRA bot hs aeBusiness Economics ee when TP, falls, MP, is negative. Its economic meaning is that 4 Tiuditional labourer slows down the production process i.e, total Sutput falls. This implies that MP of that worker is negative. ‘TP, is the area under the MP, curve. ‘The falling portion of the MP, curve illustrates the law of variable proportions. 7, MP, is positive as long as output (TP,) is increasing, but becomes negative when output is decreasing. gelationship between AP, and MP, Curves Initially when both AP, and MP, curves are rising, MP, curve rises at a faster rate than the AP, curve. This is because for average to tise, the marginal must be greater than the previous average. Both AP, and MP, curves rise till the fixed factor(L) is under utilised. When both AP, and MP, curves are falling, MP, curve falls at a faster rate than the AP, curve. Both AP, and MP, curves start falling once the fixed factor (L) is fully utilised, 4, When AP, curve is neither rising nor falling, MP, = AP, ‘There is a range, shown from point C’ to A’, where even through the MP, curve is falling AP, curve continues to rise. 5, The relationship can be proved mathematically as follows: APL are, = ah MP. = APL) ‘aL. 2AR, nar op MP, » Production Dot. ; 6. HE LAW OF VARIABLE PROPORTIONS = 6.3.1 The Statement of the Law i alpine PP ily dered nd wading ae other face stcteased by using one of the variable fi Egos all other factors fixed, le factor while keeping The law of variabl pene le proportions was initially called ten Tatine ations by Marshall. Law of dimisishing set ses of at an increase in the capital and la Sere of fea eee eel “Land labour applied in the cultivation amount of product raised unless it epee on aeues to agriculture all applied the law only 6.3.2 Assumptions re ditt Of variable proportion (or the law of diminishing returns) is le proportion (or the iin g ) 1. State of production or technology remais remain unchanged. 2. All units of the variableBusiness Economics Fig. 6.2: Stages of Production _ Stage I: Stage of Increasing Returns Stage I goes from the origin to the point where the AP, is maximum (ie, from origin to point b). In this stage, TP, is initially increasing at an increasing rate and then starts increasing at a decreasing rate from the point of inflexion (point C) onwards. AP, rises throughout in this stage. MP, rises initially and then starts falling. The increase in AP, and MP, curve is due to the fact that fixed factor land is underutilised. Increasing returns are due to indivisibility of factors and specialisation of labour. ‘A rational producer will not operate in this stage because the producer always has an incentive to expand through Stage I of labour. When price fof labour is constant, a rising AP, means the average cost decreases as output is increased. If the firm is in a competitive industry, it would never produce in this stage since by raising the level of output it can further fuce average cost, It means profit will rise if the producer expands the Production % Stage I: Stage of Negative Ret Stage I covers the entire range over which MP, is negative. A 2 groue ln opr ns stage sven wil ree inbour bru se his output by employing less labour. That fs, use of ser factor lesds to ineficencies. te non-economic and ineficcet segon range of diminishing retums described by tage I. The law of diminishing plies a declining marginal product. aed The law of diminishi: P een inputs and output. It has been wi 3 omen rapa dled aca aghast Mi ‘us’s population theory, David Ricardo’s rent theo: Esato 1e principle of diminishing retums. oee chin the ler of able erence tage of the law of retums toa factor or ‘hich takes place in the short-run. Increases each Bom origin sa manimum|to point and then starts| ce increases an at al mum point . decreasing rate Falls continuo-|From point usly till it is|b to point equal to zero oe Itisnegative [Point a onwardsBusiness Economic 610 a ‘The long-run production function can be represented graphically by Iso quants or Is0-product curves. 641. Production with Two Variable Inputs—The Concept of Tsoquants ‘the word Tsoquants simply means equal quantities (prefix ‘Iso’ means aoe caine and ‘quant’ means quant). An isoquant shows the Ginterent combinations of labour and capital with which a firm can produce dispecific quantity of output. An isoquant is defined as the locus ofall the technically efficient combinations of inputs which yield a given amount of utput le shows firm's flebility when making production decisions. Fig, 63 lutrates a set of three isoquants (where quantity of labour input is taken on the x-axis and quantity of capital input on the y-axis). In the fig, J = It is the first isoquant showing, say 50 units of output. This amount of output can be produced by many different Combinations of labour and capital shown by this isoquant The producer is indifferent between these combinations of Jabour and capital lying on the same isoquant. A movement along, an isoquant shows same level of output and different input ratio. I= 150 units = 100 units 1=[Link] production 611 1, Inthe Relevant Range, Isoquants are Downward Sloping ‘A downward sloping isoquant means that if a firm wants to use more of labour then it must use less of capital to produce the same level of output ‘or remain on the same isoquant. The firm will not operate on the itively sloping ranges or non-convex portions of an isoquant shown, by points g and h on isoquant I because these ranges show that the firm ‘uses more of both labour and capital to produce the same level of output Jn these ranges, the isoquants "bend back upon themselves”. These are ‘uneconomic ranges. The efficient ranges of output are those over which marginal product of factors are diminishing but positive. The efficient or economic ranges are separated from inefficient ranges by drawing Ridge lines. Ridge lines are loci of points on isoquants where the marginal product of the factors are zero. Along the upper ridge line, MP, = 0. It ineans capital is used to its intensive margin. The MRTS,, is infinlte, ie, MRTS is undefined at this point. Along the lower ridge line, MP, = 0. It shows intensive margin for labour. Thereby, MRTS of capital for Tabour jis zero. (That is, at this point labour has been substituted for capital to the maximum extent.) Inside the ridge lines, the techniques of production are efficient. Hence, isoquants are downward sloping in the relevant ranges as shown in fig. 6.4. The relevant range represents stage II of production where MP of each factor declines continuously but do not reach zero. Such production functions have been widely applied in econometrics and statistics. MATS,.= ©) Lowor ridge ine (MP, = 0,612 Business Economics The slope of an isoquant is called marginal rate of technical substitution of Iabour for capital, symbolically denoted as MRTS;q It is the rate of trade-off of one factor for another. In other words, the dope measures the degree of substitutability of the factors. It also means thet within limits, labours and capital can be substituted for each other, Ty slope of an-isoquant is graphically shown in fig. 6.5. . we r ° a Fig. 6.5 :Isoquants are Convex to the Origin ‘Slope of an Isoquant Taletael ed MRIS,, is defined as the amount of capital that the firm is willing to give up in exchange for labour, so that output remains constant. The slope of an isoquant (in absolute terms) decreases as we move down along an isoquant showing increasing difficulty in replacing capital with Jabour. That is, the producer is willing to sacrifice lesser and lesser Units $f capital for additional units of labour. It's economic meaning is that labour becomes tess productive and capital becomes more productive. Thus, we need less capital to keep output constant. Hence, MRTS is ‘liminishing and is called the Principle of Diminishing MRTS,,. can d mathematically since MRTS,, is equal ct of the factors. Symbolically, Production ie Since we are moving along an isoquant, change in output (d%) zero. Thus, dX = (MP,) . (AL) + (MP,) - (2K) es 0 = (MP, . (@L) + (MP,) - (0K) ok _ MB. o ~ aL ~ MP. MP, 30 METS = ja ‘soquant, more and ‘The above equation shows that as we move along an isoquan more of labour is employed implying MP of labour diminishes and that Gf lesser input capital, Mi, will increase. Therefore, the ratio MP,/MP, falls ‘e, MRTS or slope decreases. Hence, isoquants must be Convex 10 the origin stration, What will happen to isoguant when more capital is used in place of labour and in the reverse situation? Solution. When more capita is used in place of labour, isoguant will be steeper an inthe reverse situation when more labour i added in place of capital, Ssoquants wil be latter. 3. Isoquants Never Cross Each Other In fig. 66 twoBusiness Economics Point P implies that the firm can produce two different levels of output ~ (hith the same combination of labour and capital. This is illogical and . Absurd, Hence, isoquants can never intersect each other. 6.5 ISOCOST LINE ‘An isocost line shows the different combinations of labour and capital that a firm can buy, given total outlay (TO) and the prices of the factors. ‘An isocost equation is given as : fro = P,.L+P,.K where TO = Total outlay P, = Price of labour L= Quantity of labour Py Price of capital K = Quantity of capital on Re sr = ( f K=0,L=70/P, {shown as point B in Fig. 6.7(4)] x Panel K Panelé i zor, 4 ts socost line a Higher cost : | ror, ° ig ar o Production 615 6.6 PRODUCER'S EQUILIBRIUM producer is in equilibrium when he has least cost combination of inputs, for this, a firm requires that the MRTS,, be equal to P,/P, ratio. There are two cases of producer's equilibrium which must be carefully distinguished from each other. Case 1: Maximise Output Subject to a Cost Constraint 1 cost is a constraint then the producer maximises his output subject to fa single isocost line (AB). The firm's equilibrium position is shown in Fig, 68. where [AB = Isocost line showing cost constraint 1, I III, V = Several isoquants, the higher isoquant showing greater output. Point E = Point of producer's equilibrium. It shows maximum possible output the firm can produce given the isocost line. Points above E are desirable but not attainable given. the cost constraint. ‘At point E, the isocost line AB is tangent to the highest : possible isoquant III. At the point of tangency, the absolute slope of an isoquant is equal to the absolute isocost line. Thus, the producer's. Mm. 2 Case 2: Minimise Cost Subject to an Output Constraint If output is given, then the producer will aim to minimise his cost subject to a single Isoquant, I. The producer's equilibrium is shown in fig. 6.9. cere in K A A 4 A 1 ° a 6, 6 B, L soducer’s Equilbrium with an Output Constraint = Isoquant showing output constraint. Several Isocost lines. The higher isocost line shows higher total cost outlay. Isocosts are parallel to ‘each other showing same slope. This is because the slope of an isocost is equal to P,/P, and price of factors remains constant by assumption. point E «Point of producer’s equilibrium. It shows the "minimum cost of producing the given output. ts below E are desirable as they show lower ut are not attainable. 637 Production [slope of txoquant] = (Slope of isocoet line] , or MRTS ze = Py ALE eee Co poaaae s convex to the odin =) and the isoquant must be 6.7 EXPANSION PATH 6.7.1 Long-Run and Short-Run Expantion Paths i is constant. Th ‘An Inocline is the locus of points along which MRTS is constant. They an bo of any shape. For example, ridge lines drawn in fig. 64 are tsocines Ginere along the upper ridge ine MRTS,, is infinity and along the lower ridge line MRTS,, is zero. If the firm increases its total outlay, then there will be parallel Sutward shifts of the isocost lines (prices of factors remaining constant). ‘These different isocost lines will be tangent to different isoquants, thus giving different equilibrium points. By joining these points of producer's e{uilibrium, the firm’s long-run expansion path is obtained. The long run expansion path is said to be optimal as it choses those factor combinations which minimises the cost, given factor prices and the production function. It is graphically illustrated in Panel A of fig. 6.10 by line, OR. The figure also shows a short-ran expansion path by the line KT. Tt shows that in the short-run capital input is fixed in quantity at (OK. The firm can expand its output by employing more labour on fixed capital ‘The long-run expansion path need not be a straight line. An expansion path in the general production function is shown in Panel C as line OB. OB = It is long-run expansion path of a firm with a general production function, It i a particular tsocline along which MRTS is constant. Along OB, MRTS,, is equal to the existing eee satis. This expansion path shows how K/L ratio changes when output changes (factor prices remainin constant). eee poe . In Panel D, OA = It is a long-run expansion path of a firm with a linearly homogeneous production function. It is a straight line from the origin. It implies that the K/L ratio depends only on the factor price ratio (w/r). The slope of expansion path = K/L. The production function shows constant returns to scale. The isoquants are equally spaced and parallel along, ta cml ae he Om eh ee Cl ah she VSBusiness Economics E Parole 5 | Capital ee Capital ” A, Longe ‘Expansion Path t {4 ‘a A f Stortnin N i zi Expantion Path aT eee I e We Blab Tabor Long-nun and Shor-un Expansion ‘Homothetic Production Function Paths PanelD A Expansion K : Pat, A ‘a Ba A a8 F t Expansion Path In a General Expansion Path in Linearty Production Function Homogeneous Production Function Fig. 6.10 : Expansion Paths Expansion path is a straight line from the origin. Such an isoquant map is called homothetic. production function is drawn in Panel OA expanston path. ‘isoquants I and II are equal along any Production 619 a production function. If the production function is linearly homogeneous, it implies: Result (1) If all inputs are increased in the same proportion then output will also increase by the same proportion when constant returns to scale prevails. Result (2) The average and marginal product functions depend only spon the ngt ato ‘isa, hosiogencous fanction is always imate, but the reverse i fot necessarily tre Example, Cobb-Douglas production function, which is given as: Q= ALK () where Q = Output 1 = Labour input Ke Gopal gat , B = They are positive parameters determined in each case by the data. A= It is a positive constant. Greater the value of A, more advanced is the technology. = It measures the percentage rise in output resulting from 2.1% rise in labour input, Keeping capital constant. Ibis output elasticity of labour. i = It measures the percentage rise in output resulting from’ 1% rise in capital input, keeping labour constant. It is output elasticity of capital, Three situations can take place |, (If +B = 1, it implies constant retums to scale. If a +P >1, it implies increasing returns to scale. (iti) a +B AB > BC. Constant returns to scale operates when the distance between successive isoquants is same, ie, BC = CD = DE, Decreasing returns to scale operates when the distance between successive isoquants is increasing, i.e, DE AC, then E, > 1. 1 implies there scale. ‘These economies of advantages can be of two types: E, = 1, implies there are neither economies diseconomies of 4. Internal Economies ‘These economies arise because of the actions of an individual firm to ‘economise its cost. 2, Extemal Economies “These economies are not a direct result of efforts made by the firm itself tut are enjoyed by the firm because some other firms in the industry have made use of it and this firm copies it from those firms. Iis difficult to draw a line of demarcation between internal and external economies, What may be extemal economy at a given time may become {intemal at another time. Type 1: Internal Economies Internal economies are of six kinds. 1. Trcwicat, Bconowaes “Technical economies arse to 2 firm because of the large size of the firm, Such type of economies are possible in industry, agriculture, mining and Giher geeupatins also. These economies of techniques are further sub- divided into : (a) Economies of rior techniques. When the size of the firm grows it becomes pn Mo taveToigger and better type of machines to improve the technique of production and thereby reduce the cost. (0) Economies of intreased dimensions. A big firm enjoys reduction in cost ‘when it increases {ls dimensions, As the dimensions grow, a big firm “have the various processes of production conducted within the aves time and cost. times, it is not ible for a firm to Seathuced within the premises linked processes, ic, different firm ab far as production Is > m mt a ie SS a ral oa 3 = oy = production 6a Fania soosontas ces fot era wlan aoe eee be to) Spechltaton of managment. tis pote for 2 eg fm to make ‘Pion of sanagetal tak The satel att tee fic ana pari ec aie tes cant i ege hes Te cia of wee eres ie a oat 0 ea on ele eae rt Ste eitcient working of the fire Hue aed eli dtemniraluntion of decion making (3 enti of mae ions. imate iim ply ccs of warepeneet spe Eee Tecarieton fh te wer machines wlevilon se, espa Fe ecg mre ae eae ee Rerlpeerigepreere ce eres 3. Marxeinc on Commanciat Econosies Maskting economies refer to such reduction in the cost of 7 ion in production: wc ccd by he pschase of pus at he owt pean te a good at the Nighest possible pice. In other words, market economies arise due to e ~~ o e (e) eanamie of purchee.& arg Sem purchases raveenaerss andl other fetes o proton ona ge snl. Basoe tS parse,» lee frase train power obra! flaca rice. Also, a large firm may employ more and better ‘peinced sn to deal oh al gta ce ea (©) Heonomis of sal. & lage fim can bring about-seution in the cost selling by employing a highly specialised staff well-versed in the 2 of pushing up sales. Also, a large firm may take up more advertising activity fo push up sales, Further, large frm can ener exclusive agreements with distributors and wholesalers, wh« undertake the obligation of maintaining a good service departnent for the product of the manufacturer, ee 4. Fmanctat EcononansPecan as Business Economics S. Rox Bown Econo Risk bearing economies may be secured in matters of risk as large firms are ina position to bear risk. Large firm can diversity these, (4) Ouipst (Le, produce more than one product) (8) Matket (ie, supply the product in more than one market) (©) Sources of supply (ic, get the supply of raw materials fom more than one source) (f) Process of manufacture (i.c., to have alternative process of manufscturing available). 6, Lavoun coronas Labour economies arise for various reasons, the most important being ‘specaliation and division of labour. tn. a large firm, work ie divided ang ‘sch labourer specialises in one particular process. This improves thelr shill and increases their efficiency in thelr field of specialisation. They are perfect in their field. It increases the amount of output, reduces labouy ost per unit and saves time, Type 2: External Economies External economies are external to the firm. External economies arise to 4 firm because of expansion of an industry. They are of three kinds 1, cononats oF Conceyreanion Economies of concentration arises because of concentration of firms in a Particular ares. It gives rise to the following economies : (@) Labour; All firms get better and more skilled labourers without doing any effort. Since they are skilled, it saves the cost of training them. () Financial: All firms get better financial facilities. The facilities are ‘easily available and cheaper in cost. ) Transport and Storage: All firms have an access to better and cheaper Port facilites and storage facilities. Huge storehouses are. built 629 Production gives all the vital statistics. Separate si bound to be very expensive. That is why, by each firm saves time and cost. surveys and collection of date ie ‘conornes of information reaped 2, EconosaEs oF DisivTEcRATION calsation or concentration of industry gh economies of Ufintepron Ose sgl foes not produce enough wastage or by conomies of * products to enable some specialised firm to make use of them. But if = Taege number of firms are established at one place, then it is possible to have more specialised firms making use of by-products. For example, comb, button, knives, glue are all made of wastage or by-products. 6.10.2. Diseconomies of Scale isconomies of scale simply means that the firm grows 20 large that it becomes ey dificult to manage fin other words, there. sre difficulties disadvantages and inefficiencies which accrue to a firm when it expands beyond the optimum capacity. Tt increases the cost and gives riee to decreasing retums to scale. These diseconomies or disadvantages can be of eo type 2. Intemal Diseconomies Injemal diseconomies are intemal to the firm, They are defined as those diseconomies which enable the firm to produce less efficiently at Some levels of output 2. External Diseconomies External diseconomies are extemal to the firm. They are defined as those disadvantages in production which depends on increase in the output of the whole industry and not on the output of an individual firm. Type They are of four kinds,” : Internal Diseconomies 1. Tecimacat. iseconomaes, Technical diseconomies arise if production is increased beyond the optimum point. When production takes place beyond the optimum point, the maintenance cost rises, risk of accidents are more and in case of an accident heavy losses are made.a lll” Business Economics 631 Production fig, 617 to fig, 620, The fundamental concept 9 thal the returns to seule $6 be increasing, constant or decreasing but when the short-run condition Same factor being constant is imposed, the returns to the warble factor are o ortually diminishing. There i only one exception—the case of very Strong increasing returns to scale (IRS) 617, the production function shows Increasing returns to scale nndition of one factor being constant (K) is hing productivity of the variable factor 630 3. Risk ARNG OSECONOMIES isk bearing dueconomies arise when diversification is increased beyond Ae primum limit. When too much diversification is taken up, liquidity te jcee In cate of large firms, risk of strike and lockouts are more, 4. ManacesAL osecononns Managerial diseconomies arise when manager is overburdened with Gutput exceeding optimum level. There is scarcity of factors of production Sad there is imperfect substitution. The manager is overburdened and faces the problem of control and coordination. The result is that managerial problems and inefficiency increases. ‘Type 2: External Diseconomies External diseconomies arise to a firm in the form of rise in unit costs because of expansion of an industry. External diseconomies are external coats that spill over into other firms costs. Some examples of external diseconomy are = 1. A firm in course of expanding its output causes so much pollution that it increases the cost of disposing waste materials for other firms in the same area. Pollution of lakes and rivers creates external diseconomy for the Eishing industry and health hazards for consumers. 3, Creation of 2 new shopping complex increases traffic causing ‘external diseconomy to the inhabitants of that area. In the fig. “4. Concentration of firms in an area increases the wage rate to all ere. OT = Itis the scale line. It shows the long-run expansion path of me ts output when the scale of operation is changed. 6.11 RETURNS TO FACTORS 2s. RETURNS TO SCALE IRS = Increasing returns to scale are shown by the fact that when both factors of production are doubled (2L and 2K), output more than doubles. In (URS). When the short-run cor imposed, the effect is diminis! (abour). Retums to a factor and returns to scale are two very important laws of production observed in the real world. Returns to a factor states that 4 fiven a exrtain quantity of fixed factors and technology, the marginal KR-= It is the proportional line. It describes the technically Product of the variable factors will eventually diminish—elso called the possible short-run of expansion path when capital is ‘aw of diminishing returns. The law is applicable when some factor like constant (K). jabour is variable and ather factors like land or capital is fixed. Thus, Point C = If capital is kept constant at K and labour is doubled, the result is the output level shown by point C which lies on a. phenomena. In the long-run, lower isoquant 2°X. ‘A change in output takes place when It shows that if the production function shows IRS, the returns to = is factor are eventually diminishing. function Re SP TO Oe reBusiness Economics Fig. 6.18 : Constant Returns to Seale and Returns to a Factor In the fig, CRS = Constant retums to scale are shown by the fact that if both Tabour and capital are doubled, output also doubles. Point C = If capital is kept constant at K and labour is doubled then output takes place at point C which lies on a lower isoquant j ax: It shows that if the production function shows CRS, the returns to a factor are eventually diminishing. In fig, 6.19, the production function shows Decreasing returns fo scale (DRS), In this case, when capital is assumed to be constant, the returns I toa factor will always be diminishing. production oe where 10 scale are shown by the fact that if DRS = Decreasing returns & path labour and capital are doubled, output less than doubles. Point C = If capital is kept constant at K and labour is doubled then ‘output takes place at point C which lies on a lower isoquant Te tt shows that when production function shows DRS, the returns toa factor ioe duniniting “So, an exceptional cate of very strong IRS is shown. In this sn fig. 6. fo be constant the returns to a factor are ‘case when capital is assumed increasing, Proportionalline Fig. 6.20 : Excoptional Case of Very Strong IRS. IRS = Very strong increasing retums to scale. Poi C= 1 apts het cata aK and lbour is doubled then e output takes place at point C which lies on a Iroquant 2°X. Ths is becanse the increming returns to ale are so stron, ini ie so strong as to offtet the diminishing productivity of It shows that if the. Iction function to eee Penne cere ore IS, the retaneSS 634 Business Economics 6.12 SOLVED ILLUSTRATIONS AMlustration 2. : If two factors of production have the same price, what is the slope of Isoquant at the least cost output? Solution. Slope of isoquant at the least cost output is: & Mers,.= Since P=? MRTS,.=1 Iustrations 2 LMP, = 3, P= Re 1, MP. = 6 and P, = Rs. Is the fim employing cost ‘minimization Combination of input K & L? If not what should the firm do? Solution. = 2 = Slope of Isoquant MPP For cost minimization combination of inputs, we need 3¢p"~ P- since MZ -3. se fin is n0t employing cost minimizing combination a of mga KEL The firm shoaid woe more capital and less labour. Production 635 3, Production function can be symbolically expressed as: X=fLKREVS) where X is the level of output, L is labour, K is capital, R is raw materials, E is efficiency, V is return to scale and $ is land. There are two types of production function: (a) Short-run production function: where some factors are in fixed supply. (8) Long-run production function: where all factors are in variable supply. Production in the Short-run 1. The three concepts of production in the short-run are total, average and marginal product. Total product is total quantity of goods produced bya firm withthe given inputs daring a specie period “Average product is the amount of output per unit of the variable factor employed. Marginal product is the change in total product resulting from the employment of one more unit of variable factor. 2. TP, curve starts from the origin, rises at an increasing rate, then rises at [Link] rate, reaches a maximum and then starts falling. 3. Both AP, and MP, curves are graphically derived from the TP, curve. Both AP, and MP, curves are inverted-U shaped. They have special relationship which is as follows: (2) When AP is rising MP, > AP, (©) When AP, is at its maximum MP, = AP, (© When AP, is falling MP, 0, then MC > AC fined cons. The firm’ long-run decisions are called plaming decisions. In are few constrai a I slope of AC = 0 then MC = AC nxn long-run pfs by scing Sarthe padactos eco or eee tee hates pase scale of plant) that minimises cost. The firm has to very carefully decide the short-run plant size it wants to build on the basis of the future demand of the product, developments in technology and changes in the prices of inputs. A wrong decision will lead to higher production costs and less profits. For this reason, the long-run cost curves are very important as they help in careful choice of a production te ology 7.3.5 Relationship between MC and AVC Relationship between MC and AVC curve is identical to the selationship between MC and AC, This is graphically illustrated in fig, 7.10. Other4 7.16 Business Economics We will be deriving LAC and LMC in this syllabus. i 7.4.1 Long-Run Average Cost : An ‘Envelope’ Curve The LAC shows the average cost of production when all factors are in variable supply. It shows the minimum per unit cost of producing each {evel of output when the capacity of the firm can be varied. The LAC curve is derived from the short-run AC (SAC) curves. LAC curve is a curve tangent to all the SAC curves. It represents infinite plant sizes that the firm could build in the long-run, ‘Assume that at a point of time there are only three methods of production available to the firm. Each method has a different plant size as shown graphically in Fig. 7.11. = LAC Answers the Question : Which Plant Size to Install to Produce a Particular Level of Output? where SAC, = These are costs of the small plant. SAC, = These are costs of the medium plant SAC, = These are costs of the large plant. ‘The firms Ee Cost at Xj level of output. What it conveys is that if a firm wants to produce X, output in the long-run, it should produce it with medium plant to minimise cost, In reality, the firm has infinite methods of production available, each represented by a different plant size. Fach plant size is represented by 2 different SAC curve. Each point on the LAC curve shows the minimum cost per unit for producing the corresponding level of output. LAC is graphically derived in Fig. 7.12. SAG, saa ac oa sac, Reo 2 c 1 1 ore nefm Bcc % > Increasing Retums a Increasing Retums to Scale “™ Decreasing Retums to Scale * Fig. 7.12 : Derivation of LAC Curve from SAC Curves where LAC = Long-run average cost curve. SAC = Short-run average cost curve. LAC is a continuous curve. Each point on point onthe SAC whichis tangent tote LAC at a eee Seaas Business Economics LAC curve is called an envelope curve because no part of SAC curve can ‘ever be below the LAC curve. LAC curve envelopes all the SAC curves The reason why LAC curve is an enveloping curve is that there is no reserve capacity ie, each plant size can produce optimally a single level of output. One unit lesser or greater leads to increased cost. It is becouse SAC curve is U-shaped that LAC curve envelopes the SAC curves. If SAC curve was saucertype shaped, then LAC curve could not have been an enveloping curve. AC is a planning curve because if the firm plans to produce output X, at minimum cost then LAC curve helps the firm in deciding that the most appropriate plant size would be SAC, Any other plant size built to produce output X, will lead to increased production costs and less profits, The LAC curve is said to be a cost frontier because it separates the inefficient levels of cost from the efficient levels of cost. Any point above LAC curve is attainable but inefficient in that it shows a higher cost of producing the corresponding level of output. Any point below LAC curve ‘is efficient but is unattainable with given state of technology. {In an exceptional case, LAC can be a horizontal straight line. This will happen when retums to scale are constant over a wide range of output, Its shown graphically in fig, 7.13. “ % my Fig 7.49 : LAC Curve Is a Horlzontal Line Showing CAS LAC curve, which is an efvelo ‘a flat bottom which implies tat soll fens coesat ade By olde eh pe tics industry. In such a case, there 1s nop SAC, SAC, and SAC, are just & portion of LAC is formed, by Many empirical studies Cost 719 by the locus of the minimum points of the corresponding SAC curves In this case, LAC = LMC. However, it does not imply that if the production function of a firm exhibit increasing returns to scale at all levels of output, then its LAC curve will be declining. This is because LAC depends on technology and market opportunities. When scale is increased by say 10%, then total cost also increases (ie,, wage of additional labourers and interest on additional capital). It is possible that production may increase by more than 10% and costs may also increase by more than 10%. In such a situation, LAC would be rising. 74.2. Long-Run Marginal Cost (LMC) : Not an ‘Envelope’ Curve There are two ways of deriving the LMC curve. These are : 1. The LMC measures the change in LTC per unit change in output. aLTc or imc = a{LAC.X) or IMc = In this way, the values of LMC can be mathematically computed, ‘The LMC curve is U-shaped. The relationship between LMC and LAC curves is same as that between short-run MC and AC curves. 2. The LMC curve is derived from the short-run marginal cost (SMC) curves, but does not envelope them. The graphical derivation of the LMC curve from the SMC curves is shown in Fig 7.14. where’ SMC = Short-run marginal cost curve. SAC = Short-run average cost curve. LA LMC = Long-ran marginal cost curve. ‘The LMC curve is the locus of points of intersection of the SMC curves with the vertical lines drawn from the point of tangency of the corresponding SAC and LAC curves. The SMC curve can lie below the LMC curve. ‘The steps of construction of LMC curve are ; 1, First draw the LAC curve as an SAC, AND 5 Long-run average cost curve.720 Business Economics 3. From the point of tangency of SAC and LAC curves draw vertical lines to the x-axis (ie, from point ¢, b and ©) 4. Plot the points where these vertical lines intersect the SMC curves, These will be a’, band ¢’ 5. Join all these points to obtain the U-shaped LMC curve. 0 Shewsing—>— x, ———+ Retums to Seale Decreasing Returns to Scale Fig. 7.14 : Derivation of the LMMC Curve trom the SMC Curves To the let ofthe lowest point of the LAC curve, point M, LAC curve lies above the LMC curve. At point M, the LMC curve intersects the LAC curve. To the right of point M, the LMC curve lies above the LAC curve. At point M, SAC = LAC = SMC = IMC 6. Point M' (which is the minimum point of LMC), will lie to the left of point M (which is the minimum point of LAC) 7.8 RELATIONSHIP BETWEEN PRODUCTION FUNCTION AND COST £URVES ‘The relationship between production function and cost curves is simply that production function of a firm together with the prices of inputs that the firm must pay for them determines the firm’s cost curves. Mathema ‘ f Cost 7a 2, = Quantity of labour TVG, = Total variable cost of labour. ‘The graphical relationship between the production functions and cost curves is shown in Fig. 7.15. Cost curves we shown by the TP, tthe MP, curves can be derived: s Obtained by multiply our. That sr hom"When AP, curve rises, AVC curve falls. Business Economics ts the monetized mirror image of the AP, curve and C Sis the monetized mirror image of the MP, curve. ‘AP, curve is maximum, AVC curve is minimum, When AP, curve falls, AVC curve rises. When MP, curve rises, MC curve falls When MP, curve is maximum, MC curve is minimum. ‘When MP, curve falls, MC curve rises State IT of production—the stage of diminishing returns—begins fat point A or As, where MP, is eventually declining and MC is rising cost 723 7.6 SOLVED ILLUSTRATIONS illustration 1. A firm is producing 20 units. At this level of output, the ATC and AVC are respectively equal to Rs. 40 and Rs. 37. Find out the total fixed cost of this firm. Solution: TFC = AFC x output = (AC ~ AVC) x output MMustration 2. If TC = (50 + Q) (90 + Q). Find TEC, AFC, TVC, AVC, AC and MC. Solution: TC = TFC + TVC TC = 4500 + 1409 + TEC = 4500 TVC = 140+ 4500 AFC = 2200 q Mase ave = HO=e" Q ac = SHAS Q MC = 2Q + 140. Cost ' Cost is defined as the payment made to the factors of production used in the production of the commodity. Cost ~ Different Concepts 1. Opportunity Cost Tt is defined as the cost of alternative opportunity given up or forgone. It is also called alternative cost or transfer earnings.724 Business Economics 12. Private Cost vs. Social Cost . Private cost is the money cost incurred by a firm in producing a Cimmodity. Social cost is cost of producing a commodity to the society as a whole. i 3. Shortorun Cost vs. Long-run Cost Short-run cost occurs when some factors of production are in fixed supply. Long run cost occurs when all factors of production are in variable supply. 4. Fixed Cost vs, Variable Cost Fixed cost do not change with a change in output, Variable cost vary with the quantity of output produced. 5. Economic Cost vs. Accounting Cost Economic cost is the cost to a firm of utilising resources in production including opportunity cost. Accounting cost is the actual expense plus depreciation charges for capital equipment. | Short-Run Costs—Total, Average and Marginal Costs ‘There are three costs in the short-run—TC, AC and MC. 1. Total Cost It is divided into two parts TFC and TVC such that TC = TFC + TVC. TFC is overhead cost and it remains constant or fixed whatever be the level of output. TFC curve is @ horizontal line parallel to the x-axis. TVC is cost due to increased use of variable factors like raw material, labour, etc. TVC is inverse-S shaped starting from the origin due to law of variable proportion. TC is aggregate of TFC and TVC. TC curve is inverse-S shaped starting from the level of fixed cost. The feason behind, its shape is the law of variable proportion. 2. Average Cost From the TC = TFC + TVC equation we obtain AC = AFC + AVC. AFC is fixed cost per unit of output produced. It is a rectangular hyperbola. AVC is variable cost fer unit of output produced. It is U-shaped due to law of variable proportion. AC is also called average total cost (ATC). It can be obtained in two ways: Tc (0 AC = 5. It gives U-shaped AC curve, The reason behind its shape is the law of variable p 3 728 Cost joint of AC curve will always shaped AC curve. The minimum point of AC etree ar Sccur fo the right of the masini 3, Marginal Cost MC is addition made to TC (or TV! protec 46 = STE, Cite slope of be TC curve at each pont oF between any two points. MC curve is U-shaped reflecting the law of wanlable proportion. 4. Relationship between AC and MC ‘C) when one more unit of output is Tr 1. AC and MC curves are derived from TC curve since AC = > and arc ‘ax 2. Both AC and MC curves are U-shaped reflecting the law of variable proportions. When AC is falling, MC is below it. When AC is rising, MC is above it. When AC is neither falling nor rising, MC = AC. ‘There is a range over which AC is falling and MC is rising ‘MC curve cuts the AC curve at its minimum point. 5. Relationship between AVC and MC The point of relationship between AVC and MC and MC are same as those betwe AC and MC. The aren under the MC curve gives Beane ene Long-Run Costs MC In the long-run, all factors are in variable i ariable supply. Thi i the lege LAC, LIC and EMC. Both LAC and LMG ate Uahegee ae turns to scale. LAC i vel is a eiveniais 's an enveloping curves and LMC is not an 1, Production function of 3 coiigion fancon of 5 Ae 2. AVC and MC is the:te 10. i, Business Economics Explain the shapes of short-run cost curves. Analyse the relationship between AC and MC curves. If the MC of firm is rising, does it mean that its AC is also rising? Why or why not? Distinguish between AFC, AVC, AC and MC. Show their mutuaj relationship. Write short notes on : (a) Explicit versus Implicit costs. (b) Relationship between production function and cost curves. Explain that LMC is derived from short-run MC curves but does not envelope them. Briefly explain reasons for shift in cost curves. Write short notes on: (a) Accounting cost vs. Economic Cost, (0) Private cost vs. Social cost, (c) Opportunity cost, (d) Sunk cost vs. Fixed cost, and (e) Explicit cost vs. Implicit cost. How do economies and diseconomies of sale affect the firm’s long- run marginal cost curve? Why? (a) What is the relevance of Accounting Cost, Economic Cost and Opportunity Cost in making any economic decission. () Explain the relationship between Marginal Cost, Average Cost and Average Variable Cost. Explain how TVC curve can be derived from a TP curve. What is ‘Sunk Cost’? Explain why it should not influence a firm’s decisions. (@) Distinguish between sunk cost and fixed cost, (8) Derive LAC from short-run Plant curves. Also explain why LAC curve™is flatter than short run cost curves? cu the short-run AC be less than the long-run AC? Why or why not? Explain that long-run’ marginal cost curve is derived from short- Fun marginal cost curves but does not envelope them.