CHAPTER 4: PRODUCTION ANALYSIS

Introduction

Production is basically an activity of transformation, which connects factor inputs and outputs. A
farm uses land, labor and seeds as the basic inputs to transform them into corn. An input is
defined as any good or service which contributes to the production of an output.

An entrepreneur normally will use many different inputs for the production of an output. Some
of these inputs may be outputs of other firms. For example, steel is an input for an automobile
producer and an output for the steel producer.

PRODUCTION

Production is the organized activity of transforming resources into finished products. The
objective of production is to satisfy the demand of such transformed resources. It is the creation
of utility, not the creation of matter.

The process of transforming inputs into output can be any of the following kinds:

 Change in the form: raw materials transformed to finished goods. Example: iron
into machine

 Change in place: 1) extraction from earth and 2) transportation of goods

 Change in time: making available materials at times when they are not normally
available. Example: Storage

 Making use of personal skills

The fundamental purpose of all these activities is creation of utility. So, production is creation of
from utility, place utility, time utility and personal utility.

PRODUCTION FUNCTION: The production function represents the relationship between

physical inputs and physical output. The relationship can be expressed in the form of a table, a
graph, or mathematical equation. The quantitative relationship between physical inputs and
physical output is technically known as production function.

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Q = f (L, K, La,… )

Where Q = quantity of output, L = labor, K = capital La = land etc…

Production function is constructed based on the assumptions:

 The state of technology is given and the output can be increased by increasing inputs.
When the technology changes, the production function itself changes.

 It is assumed that the inputs are utilized in the best possible way, i.e., optimum utilization
of inputs.

 The factors of production are divisible into most viable units.

 The production function is related to particular unit of time.

Laws of Production: On the basis of time period laws of production may be classified into
two: ie Short Run: Laws of Variable Proportion and Long run: Law of Returns to Scale.

THE LAW OF VARIABLE PROPORTIONS or THE LAW OF DIMINISHING RETURNS

The behavior of out put in short run is explained by law of variable proportions. The law of
variable proportions or law of diminishing returns, describes the pattern of change in output
when more and more units of variable input are added to fixed factor of input. The law states
that when more and more units of a variable input are added with fixed quantities of other inputs,
the out put would not respond in a proportionate manner.

According to Joan Robbinson, the law of diminishing returns states that, “ with a fixed amount of
any factor of production, successive increase in the amount of other factors will after a point
yield a diminishing increment of the product”.

In other words the law states that a we go on employing more of one factor of production; other
factors remaining the same, its marginal productivity will diminish after some point.

For example, if we employ more units of labor and capital remains the same, the marginal
productivity of labor will at first increases but start decreasing after a certain point.. The shape of
the marginal product curve is therefore inverted U
The operation of the law of diminishing returns to factors is subject to three assumptions:

 The state of technology remains the same.

 The law is not applicable when all factor inputs are variable.

 The fixed factor remains constant..

 The variable input is homogeneous.

 Period under consideration is short run.

 Product can be produced under different degrees of input combination.

The behavior of the total product can be illustrated with the help of the schedule of an
imaginary production function with land as fixed and labour as variable input. The following
table describes the law in terms of TP, AP and MP.

No.of Total Marginal Average

Workers Product Product Product
(TP) (MP) (AP)

1 100 100 100

2 220 120 110

3 270 50 90

4 300 30 75

5 320 20 64

6 330 10 55

7 330 0 47

8 320 -10 40

The behavior of the product is conventionally examined with reference to marginal product and
average product in three stages in the following diagram:

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 In the above graph X axis represents labour i.e. variable input and Y axis represents
out put. The MP shows 3 trends viz; increasing returns, diminishing returns and negative returns.

STAGE 1: The stage of increasing returns: In this stage the total product increases at an
increasing rate. Marginal Product and Average Product are increasing. This stage continues till
AP curve reaches maximum.

In the beginning the quantity of fixed factors is abundant relative to the quantity of the variable
factor. So the efficiency of the fixed factors increases as additional units of the variable factors
are added to it. This causes increase in output at an increasing rate.

STAGE 2: the stage of diminishing returns: In this stage TP curves continues to rise but at a
diminishing rate. This is evident from the falling MP and AP curves. This stage continues till MP
curve crosses the X axis. At the point where MP is zero, the TP curve reaches maximum. The
falling MP and AP curves indicate that the total product increases at a diminishing rate. This
stage is known as diminishing returns or decreasing returns.
STAGE 3: the stage of negative returns: In this stage the TP curve falls. This is because the
MP is negative. When the quantity of variable factor becomes too excessive relative to the fixed
factor, the total output falls instead of rising. This stage is known as stage of negative returns. So
in the 3 stage the total product decreases. A rational producer will never produce in 3 stage
where marginal product of the variable is negative.

Reasons for the operation of law.

1. Wrong combination of input: if more units of variable inputs are added to the fixed factor
even after the optimum level the output shows a decreasing tendency and hence the law
of diminishing returns.

2. Scarcity of certain factors. In short period it is not possible to change all the factors of
production .So scarce resource is compensated by other available resources. This
adversely affect the optimum combination of input.

3. Imperfect substitutes: One factor of production is substituted by another factor only to a

certain extent. E.g. Capital and labour.

Law of Diminishing Returns and Business Decisions.

a. To find the optimum production function( MP=AP )

b. To decide the proportion between fixed factor and variable factor.

c. To determine rational and irrational levels of production.

RETURNS TO SCALE

The behavior of output in long run is explained by the law of returns to scale. Returns to scale
refer to changes in output when all inputs are changed in the same proportion. The law states that
when all factors of production are changed in the same proportion, output will increase either at
increasing rate, or at a constant rate or decreasing rate.

The law can be explained by the following table and diagram.

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Land Labour TP MP

1 2 4 4
2 4 10 6
3 6 18 8
4 8 28 10
5 10 38 10
6 12 48 10
7 14 56 8
8 16 62 6

The application of more units of land and labour ,till the 4 th unit of land and
8th unit of labour results in increasing returns. In this stage the total out put is increasing at an
increasing rate . this is a case of increasing returns. It is due to better utilization of plant or high
degree of specialization.

Increasing returns to scale can not be experienced by the firm indefinitely.

Firms slowly enter the phase of constant returns. In this case total out put is increasing at a
constant rate. The application of 5th unit of land and 10th unit of labour ,6th unit of land and 12th
unit of labour provide constant returns ie MP=10. The constant return occurs when the
economies of large scale operation s are neutralized by diseconomies of large scale operation.

Firm can not enjoy increasing or constant returns indefinitely. Sooner or

later firm reach diminishing returns . the application of 7 th unit of land and 14th unit of labour
results in diminishing returns. In this case total product is increasing at a decreasing rate . it is
due to diseconomies of large scale operations.
Increasing Returns to Scale: If the increase in output is more than proportional to the increase
in inputs, it is called increasing returns to scale. For example, if the inputs are increased, say by
100 percent, the output increases, say by 150 percent. When a firm expands, increasing return to
scale is obtained in the beginning. Indivisibility of factors is another reason for increasing returns
to scale. If all factors are perfectly divisible, increasing returns may not occur. Increasing returns
to scale is graphically explained below.

In the diagram IQ1, IQ2, and IQ3 and equal quantity curves (iso-quants) and they depict the
output levels of 100, 200 and 300 units respectively. Less than 100% increase in input
combinations lead to 100% output increases. Therefore, the gaps between iso-quants are smaller
and smaller.

Constant Returns to Scale: If the increase in output is proportional to the increase in inputs, it is
called constant returns to scale. For example, if the inputs are increased, say by 100 percent, the
output increases, say by 100 percent. Constant return to scale is known as Linear Homogeneous
Production Function. Graph of the constant return to scale is given below:

In the diagram IQ1, IQ2, and IQ3 and equal quantity curves (iso-quants) and they depict the
output levels of 100, 200 and 300 units respectively. 100% increase in input combinations lead to
100% output increases. Therefore, the gaps between iso-quants are same, i.e., OA = AB = BC.

Decreasing Returns to Scale: If the increase in output is less than proportional to the
increase in inputs, it is called decreasing returns to scale. For example, if the inputs are increased,
say by 100 percent, the output increases, say by 50 percent.

In the diagram IQ1, IQ2, and IQ3 and equal quantity curves (iso-quants) and they depict the
output levels of 100, 200 and 300 units respectively. More than 100% increase in input

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combinations lead to 100% output increases. Therefore, the gaps between iso-quants are wider
and wider.

CAUSES OF RETURN TO SCALE

 The main causes of the operation of increasing returns to scale are the introduction of
greater division of labor and the use of the specialized machinery. An increase in the
scale of operation leads to greater division of labor which leads to increase in
productivity.

 All the advantages arising from the expansion of scale of production are called
economies of scale. The Economies of scale is the reason behind the increasing returns to
scale.

 When scale of operation is increased too much, management and coordination become
difficult. This causes the operation of decreasing returns to scale. The disadvantages
arising out of the expansion of scale of production are called diseconomies of scale.

ECONOMIES AND DISECONOMIES OF SCALE

The advantages of large scale production that result in lower unit costs (cost per unit) are known
as economies of scale. The classifications of economies scale can be explained in the following
chart:
REAL ECONOMIES OF SCALE

PRODUCTION ECONOMIES OF SCALE arises from:

1) Labor Economies

Labor economies are achieved as the scale of output increases for several reasons:

 Specialization

 Time-saving

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  Automation of the production process

 Cumulative volume economies

2) Technical Economies of Scale

 The Law of Increased Dimensions: Cubic law can be applied where cubic volume
increases more than proportionate to surface area.

 Economies of linked processes: Production processes can be linked together with one
integrated plant – important in mass production which requires complex manufacturing
processes

 Large-scale indivisible units of capital machinery: Capable of high productivity (e.g.

presses used in the manufacture of steel products). Huge units of capital require a vast
output in order to reduce the average cost per unit.

3) Inventory Economies

SELLING / MARKETING ECONOMIES OF SCALE

Selling economies are associated with the distribution of the product of a firm. Main types of
such economies are as follows:

 Advertising economies

 Other large-scale economies

 Economies from special arrangements with exclusive dealers

 Model-change economies

MANAGERIAL ECONOMIES OF SCALE

Managerial Economies arise for various reasons:

 Specialization of management
  Mechanization of managerial functions

 Savings in administrative costs by splitting up jobs (e.g. specialist buyers, production

management)

 The larger the company, the more specialized each manager can become. In a small
business, there is usually only one manager who has to do everything.

 In a large business, there is a larger span of control, with specialist managers for each
department.

FINANCIAL ECONOMIES OF SCALE

 Bulk purchasing economies: Monopsony power of buyers of components

 Access to cheaper sources of finance: Large firms able to negotiate cheaper finance deals.

 Lower interest rates for larger businesses

 The smaller the business, the greater the risk for a bank to lend you money: The larger the
business, the less of a risk – due to experience, more products, greater diversification,
better specialist accounting managers.

RISK-BEARING ECONOMIES (LOWER RISKS)

 Diversification of products – multi-product firms

 Diversification of plant locations / retail outlets – including the expansion of

multinational business

 Research and development

PECUNIARY ECONOMIES OF SCALE

These are economies accruing to the firm due to discounts that it can obtain due to its large scale
operation.

 Lower prices of its raw materials

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  Lower cost of external finance

 Lower advertising prices

 Lower transport rates

 Lower earnings to their workers

EXTERNAL ECONOMIES OF SCALE

The advantages firms can gain as a result of the growth of the industry – normally associated
with a particular area: Supply of skilled labour, Reputation, Local knowledge and skills,
Infrastructure and Training facilities.

External economies of scale exist when the long-term expansion of an industry leads to the
development of ancillary services which benefit all or the majority of suppliers in the industry

 Cheaper raw materials and capital equipment: as industry expands, there exists the
chance for the exploration of new sources of raw materials, machinery, techniques of
production and other various capital equipments.

 Technological external economies: growth of industry may result in the development of

the new technical knowledge and its advantages can be easily enjoyed by various firms.

 Development of skilled labour

 Growth of ancillary industries

 Better transportation and marketing facilities

DISECONOMIES OF SCALE

The disadvantages of large scale production that can lead to increasing average costs are termed
as diseconomies of scale.

Diseconomies of scale lead to rising long-run average costs

 Long Run Average Cost rises due to firms expanding beyond their optimum scale
  Diseconomies are difficult to identify precisely

 They are often caused by the complex nature of managing large-scale firms and in
managing the growth of a business

 Costs of administration and coordination of the workforce

 The growth of corporate bureaucracy (i.e. which might be seen in excessive layers of
management)

 The risk of worker alienation or shirking because of the problems in monitoring the
effectiveness of workers

 Differences in the optimum scale of units of capital

 An increase in transportation costs to distant markets

 Diseconomies can lead to a misallocation of scarce resources if firms do not achieve long
run productive efficiency.

EXTERNAL DISECONOMIES OF SCALE

 These occur when too many firms have located in one area

 Local labour becomes scarce and firms now have to bid wages higher to attract and retain
new workers

 Land and factories become scarce and rents begin to rise

 The local traffic infrastructure becomes congested and so transport costs begin to rise.

THEORY OF COSTS

INTRODUCTION

The cost function of the firm gives the functional relationship between total cost and total output.
If C represents the total cost and Q represents the level of output, then the cost function is C =

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C(Q). Cost functions are derived functions. They are derived from the production functions. The
cost function can be deduced from the input combinations of the firms.

ACCOUNTING COSTS/EXPLICIT COSTS: All the payments and charges made by the
entrepreneur to the suppliers of various productive factors is termed as Accounting Costs. It
includes wages to workers, prices for the raw materials, fuel and power used, rent for the
building, and interest on the money borrowed for doing business. Accounting costs are also
called explicit costs. Accountants typically use those costs that are recorded in their books as
representing an actual transfer of money. These are explicit or nominal costs and often do not
represent full economic costs that should be considered in a given decision.

ECONOMIC COSTS: Economic costs include both accounting costs and implicit costs. The
cost of factors owned by the entrepreneur himself and employed in his own business is called
Implicit Costs.

OPPORTUNITY COSTS: It is cost of foregone alternative. In other words, opportunity cost is

the cost of next best alternative. The economic cost of an input used in a production process is
the value of output sacrificed elsewhere. The opportunity cost of an input is the value of
foregone income in best alternative employment.

OUTLAY COSTS: Outlay costs involve actual expenditure of funds on, say, wages, material,
rent, interest etc.

DIRECT or TRACEABLE COSTS: Cost which are readily identified and are traceable to a
particular product, operation or plant is direct cost.

INDIRECT or NON-TRACEABLE COSTS: Cost which are not readily identified and are
traceable to a particular product, operation or plant is direct cost. Example: cost of electric
power/unit of the product produced.

FIXED COSTS: Costs which do not change with changes in output is fixed costs. A fixed cost
is a cost that does not depend on the quantity of output produced. It is the cost of the fixed input.
Total fixed cost (TFC) is more commonly referred to as "sunk cost" or "overhead cost."
Examples: include the payment or rent for land, buildings and machinery. The fixed cost is
independent of the level of output produced. Graphically, depicted as a horizontal line
VARIABLE COSTS: Costs which change with changes in output are variable costs. A variable
cost is a cost that depends on the quantity of output produced. It is the cost of the variable input.
Examples: purchases of raw materials, payments to workers, electricity bills, fuel and power
costs. Total variable cost increases as the amount of output increases. If no output is produced,
then total variable cost is zero. The larger the output, the greater the total variable cost.

TOTAL COSTS: The sum of total fixed costs and total variable cost. TC = TFC + TVC. In the
short run TC will only increase as TVC increases

GRAPHICAL REPRESENTATION OF FIXED COST, VARIABLE COSTS & TOTAL

COSTS

AVERAGE FIXED COST: Average fixed cost is the fixed cost per unit of output.

AVERAGE VARIABLE COST

Average variable cost is the variable cost per unit of output. AVC = VC/Q

AVERAGE COST: Average total cost, often referred to simply as average cost, is total cost
divided by quantity of output produced. ATC = TC/Q

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MARGINAL COST: Addition to total cost by the production of an additional unit of output is
termed as Marginal Cost.

GRAPHICAL REPRESENTATION OF MARGINAL COST, AVERAGE COST, AFC &

AVERAGE VARIABLE COSTS

RELATIONSHIP BETWEEN AVERAGE COSTS AND MARGINAL COST

  When average cost falls as a result of an increase in output, Marginal cost is less than the
average cost

 When average costs rises as a result of an increase in output, marginal cost is more than
average cost

 When average cost is minimum, marginal cost is equal to average cost

LONG RUN AVERAGE COST CURVE

 All inputs are variable in the long-run: fixed cost may also be varied. In the long run,
there are no TFC or AFC

 Long run AC is called an envelope curve because it envelops all the short run average
cost curves as explained below:

 Long run AC is U shaped because of the operation of economies and diseconomies of

scale. The operation of economies of scale leads to downward trend in the LAC curve.
The upwards trend in LAC curve is due to diseconomies of scale. The reasons behind the
U shape of the LAC is diagrammatically explained below:

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LONG-RUN AVERAGE COST (LAC) CURVE

 U-shaped.

 the envelope of all the short-run average cost curves;

 The LAC curve is an envelop curve of all possible plant sizes. Also known as “planning
curve”

 It traces the lowest average cost of producing each level of output.

 It is U-shaped because of: Economies of Scale and Diseconomies of Scale

LONG-RUN MARGINAL COST (LMC) CURVE

 Also U-shaped;

 intersects LAC at LAC’s minimum point.

MULTIPLE CHOICE QUESTIONS

1. If a change in all inputs leads to a proportional change in the output, it is a case of

a. Increasing returns to scale
b. Constant returns to scale
c. Diminishing returns to scale
d. Variable return to scale
2. The law of diminishing returns applies to:
a. The short run, but not the long run
b. The long run, but not the short run
c. Both the short and long run
d. Neither the short run nor the long run
3. Average product is defined as:
a. Total cost divided by total units of input
b. Total output divided by total units of output
c. Total cost divided by total output
d. Total inputs divided by total output
4. A distinguishing characteristic of the long run period is that
a. All costs are fixed costs
b. All costs are variable costs
c. Fixed costs tend to be greater than variable costs
d. Fixed costs tend to lower than variable costs
5. With a given plant size, an increase in the output cannot produce an increase in:
a. Total cost
b. Average fixed cost
c. Average total cost
d. Average variable cost

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6. In the short run, when the output of a firm increase, its AFC:
a. Increases
b. Decreases
c. Remains constant
d. First declines and then rises
7. Knowledge of fixed costs and total variable costs enable one to determine which of the
following?
a. AC
b. AFC
c. ATC
d. MC
8. Which of the following curve is called envelop curve?
a. Long run TC
b. Long run ATC
c. Long run MC
d. Long run AVC
9. Difference between short run and long run is:
a. In the short run all inputs are fixed, while in the long run all inputs are variable
b. In the short run the firm varies all of its inputs to find the least cost combination
of inputs
c. In the short run, at least one of the firm’s input level is fixed
d. In the long run, the firm is making a constrained decision about how to use
existing plant and equipment efficiently.
10. Cost increase continuously with increase in output is
a. Average cost
b. Marginal cost
c. Fixed cost
d. Variable cost
11. Which of the following curve is not U shaped?
a. LAC
b. LMC
c. SAC
d. AFC
e. AVC
12. Which of the following is not a determinant of the firm’s cost functions?
a. The production function
b. The price of the labor
c. Taxes
d. The price of the firm’s output
13. Economic profit is
a. Accounting profit + implicit cost
b. Accounting profit + implicit cost + explicit cost
c. Accounting profit – implicit cost
d. Accounting profit – implicit cost – explicit cost
14. Which of the following is a function of the organizer?
a. Initiating a business enterprise
b. Risk bearing
c. Innovating
d. All the above
15. The average product of labor is maximized when marginal product of labor:
a. Equals the average product of the labor
b. Equals zero
c. Is maximized
d. None of the above
16. The rising part of the LRAC is due to:

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 a. Increasing returns
b. Diseconomies of scale
c. The increase in productivity
d. Advantage of large scale production techniques
17. Example of fixed cost
a. Labor cost
b. Electricity bill
c. Cost of raw materials
d. Salary of watchman
18. If the marginal product = average product, then:
a. MP is increasing
b. MP is decreasing
c. AP is decreasing
d. AP is not changing
19. The difference between ATC and AVC is
a. constant
b. TFC
c. Gets narrow as output increases
d. AFC
20. The shape of the TFC is
a. U shaped
b. Negatively sloped
c. Rising curve
d. Horizontal curve
21. Select the correct statement
a. TC = TFC – TVC
b. TVC = TFC – TC
 c. TFC = TVC – TFC
d. TC = TVC – TFC
22. Which of the following costs is not recorded in the books of a firm?
a. Out of pocket costs
b. Indirect costs
c. Private costs
d. Implicit costs
e. Fixed costs
23. The difference between economic profit and accounting profit is
a. Selling and administrative expenses
b. Depreciation
c. Explicit costs
d. Implicit costs
e. None of the above
24. MC is closely related to:
a. VC
b. FC
c. Opportunity cost
d. Economic cost
25. Which of the following statement is true?
a. Accumulation of capital solely depends on income
b. Saving can also be affected by the State
c. External economies go with size and internal economies with location
d. The supply curve of labor is upward sloping curve
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