MEANING OF PRODUCTION

INPUT OUTPUT

TRANSFORMATION PROCESS

ENTRY INTO FIRMS EXIT OF FIRMS

PRODUCTION means transformation of physical “ inputs” into physical “outputs”.

INPUT refers to all those things which are required by the firm to produce a particular product.

Four factors of production are land, labor, capital & organization.

OUTPUT refers to the finished product.

Production is dependent on cost of production.

Production analysis shows the relationship between physical inputs & physical output.

Higher level of production leads to higher income, employment and economic prosperity.

PRODUCTION FUNCTION

Production function expresses the technological relationship between physical quantity of inputs employed and physical quantity of output obtained by a firm.

Q = f (Ld, Lb, K…… etc.)

Where,

Q = quantity of output

Ld, Lb, K = various factors of input

TYPES OF FACTOR INPUTS

1- FIXED INPUT are those factors who's quantity remains constant irrespective of level of output produced by a firm.

Ex. Land, Building, Machine etc.

2- VARIABLE INPUT are those factors who’s quantity varies with variation in the levels of output produced by a firm.

Ex. Raw material, Power, Transport, fuel etc.

TYPES OF PRODUCTION FUNCTION

SHORT RUN PRODUCTION FUNCTION

In this case, producer will keep all fixed factors as constant and change only a few variable inputs. Ex. Law of variable proportions, iso–cost curves.

LONG RUN PRODUCTION FUNCTION

In this case, producers will vary the quantities of all factor inputs, both fixed as well as variable in the same proportion. Ex. Laws of return to scale.

THE LAW OF VARIABLE PROPORTION

(production function with one variable input)

As the quantity of different units of only one factor input is increased to given quantity of fixed factors, beyond a particular point, the marginal, average & total output eventually decline.

Stage no 1- The Law of Increasing Return

Stage no 2- The Law of Diminishing Return

Stage no 3- The Stage of Negative Return

Production function with two variable inputs

ISO-QUANT

It may be defined as a curve which shows the different combinations of the two inputs producing the same level of output.

combinations Factor X Factor Y Total output in units

A 12 1 100

B 8 2 100

C 5 3 100

D 3 4 100

E 2 5 100

ISO-QUANTS MAPS

A number of ISO-QUANTS representing different amount of output are known as ISO-QUANT MAP.

MARGINAL RATE OF TECHNICAL SUBSTITUTION (MRTS)

It may be defined as the rate at which a factor of production can be substituted for another at the margin without affecting any change in the quantity of output.

combination Factor X Factor Y MRTS of X of Y

A 12 1 Nil

B 8 2 4:1

C 5 3 3:1

D 3 4 2:1

E 2 5 1:1

PROPERTIES OF ISO-QUANTS

An iso-curve slope downwards left to right.

Generally an iso-quant curve is convex to origin.

No two iso-product curves intersect each other.

An iso-product curve lying to the right represents higher output and vice-versa.

ISO-COST LINE

It indicates the different combinations of the two inputs which the firm can purchase at given prices with a given outlay.

LONG RUN PRODUCTION FUNCTION

LAW OF RETURN TO SCALE

In return to scale, all the necessary factor inputs are increased or decreased to the same extent so that whatever the scale of production, the proportion among the factors remains the same.

THREE PHASES OF RETURN TO SCALE

INCREASING RETURNS TO SCALE

100200

350550

Factor ‘X’

Factor ‘Y’

X

Y

CONSTANT RETURN TO SCALE

100200

300400

Factor ‘X’

FATOR ‘Y’

DIMINISHING RETURN TO SCALE

Factor ‘X’

Factor ‘Y’

100190

260310

ECONOMIES OF SCALE

EOS is associated with large scale production.

EOS result in cost saving.

EOS have close relationship with the size of the firm.

It influences the average cost over different ranges of output.

It helps in reducing production cost and establishing an optimum size of firm.

EOS are classified as- Internal & External Economies.

INTERNAL ECONOMIES (REAL ECONOMY)

It arise “with in” or “inside” a firm.

It arise due to improvements in internal factors.

It arise due to specific efforts of one firm.

These are particular to a firm & enjoyed by only one firm.

They arise due to increase in the scale of production.

They are dependent on the size of firm.

It can be effectively controlled by the management of the firm.

These are called as “BUSINESS SECRETS” of a firm.

KINDS OF INTERNAL ECONOMY

TECHNICAL ECONOMIES

Economies of superior techniques.

Economies of increased dimension.

Economies of linked process.

Inventory economies.

MANAGERIAL ECONOMIES

MARKETING or COMMERCIAL ECONOMIES

FINANCIAL ECONOMIES

LABOR ECONOMIES

TRANSPORT AND STORAGE ECONOMIES

RISK BEARING or SURVIVAL ECONOMIES

Diversification of output

Diversification of market

Diversification of source of supply

Diversification of the process of manufacture

EXTERNAL ECONOMIES (PECUNIARY ECONOMIES)

It arises outside the firm.

It arise due to improvement in external factors.

It arise due to collective efforts of an industry.

These are general, common & enjoyed by all firms.

It arises due to overall development, expansion & growth of an industry or a region.

These are dependent on the size of industry.

These are beyond the control of management of a firm.

These are called as “open secrets” of a firm.

KINDS OF EXTERNAL ECONOMIES

Economies of Concentration or Agglomeration

Economies of Information

Economies of Disintegration

Economies of Government Action

Economies of Physical Factors

Economies of Welfare

ECONOMIES OF SCOPE

Economy of scope may be defined as those benefits which arise to a firm when it produces more than one product jointly rather than producing two items separately by two different business units.

C[Q1] + C[Q2] – C[Q1 & Q2]

SC =

C[Q1 & Q2]

COST OF PRODUCTION

Cost of production refers to the total money expenses incurred by the producer in the process of transforming inputs into outputs.

DIFFERENT KINDS OF COST CONCEPTS

MONEY COST AND REAL COST

When cost is expressed in terms of money, ie. Called as money cost. It relates to money outlays by a firm on various factor inputs to produce a commodity.

When cost is expressed in terms of physical or mental efforts put in by a person in the making of a product, it is called as real cost.

IMPLICIT OR IMPUTED COST AND EXPLICIT COSTS.

Explicit costs are those costs which are in the nature of contractual payments and are paid by an entrepreneur to the factors of production in the form of rent, wages, interest and profits, utility expenses and payments for raw materials etc.

Implicit cost are those which do not take the form of cash outlays and as such not appear in books of a/c.

ACTUAL COSTS AND OPPORTUNITY COSTS

Actual cost are those which are actual expenses incurred for producing or acquiring a commodity or service by a firm.

Opportunity cost may be defined as the expected returns from the second best use of the resources which are foregone due to scarcity of resources. It is also called as alternative cost.

DIRECT COSTS AND INDIRECT COSTS

Direct cost are those costs which can be specifically attributed to a particular product, a department, or a process of production.

On the other hand, indirect cost are those costs, which are not traceable to any one unit of operation. For ex- payment of electricity bill, water bill, telephone bill etc.

PAST AND FUTURE COST

Past costs are those which are spent in the previous periods.

On the other hand, future cost are those which are to be spent in the future.

MARGINAL & INCREMENTAL COST

Marginal cost is the addition to the total cost on account of producing one additional unit of the product. Or marginal cost is the cost of marginal unit produced.

Incremental cost refers to the total additional cost associated with the decision to expend the output or to add a new variety of product.

FIXED COSTS AND VARIABLE COSTS

Fixed cost are those costs which do not vary with either expansion or contraction in output.

Variable costs are those costs which directly and proportionately increase or decrease with the level of output produced.

COST FUNCTION : (COST-OUTPUT RELATIONSHIP)

The relation between the cost and output is technically described as the “cost function”.

Cost function depends on three important variables-

Production function

The market prices of inputs

Period of time

COST-OUTPUT RELATIONSHIP IN SHORT-RUN

SHORT – RUN

Short-run is a period of time in which only the variable factors can be varied while fixed factors like plant, machinery etc remains constant.

FIXED COST

Fixed costs are those which are fixed in volume for a certain given output.

Fixed cost does not vary with variation in the output between zero and a certain given level of output.

VARIABLE COST

Variable cost are those which vary with the variation in the total output.

Variable cost include cost of raw material, running cost of fixed capital such as fuel, repairs, routine maintenance expenditure, direct labour charges & the cost of all other inputs.

TOTAL FIXED COST (TFC)

TFC refers to total money expenses incurred on fixed inputs like plant, machinery, tools & equipments in the short – run.

TFC = TC - TVC

Y

XOUTPUT

COST OF PRODUCTION

TOTAL VARIABLE COST

TVC refers to total money expenses incurred on the variable factor inputs like raw materials, power, fuel, water, transport and communication etc, in the short-run.

TVC = TC - TFC

OUTPUT

COST OF PRODUCTION

TOTAL COST

The total cost refers to the aggregate money expenditure incurred by a firm to produce a given quantity of output.

TC = TFC + TVC

OUTPUT

COST OF PRODUCTION

AVERAGE FIXED COST (AFC)

AFC is the fixed cost per unit of output. When TFC is divided by total units of output AFC is obtained.

AFC = TFC / Q

OUTPUT

COST OF PRODUCTION

AVERAGE VARIABLE COST

AVC is variable cost per unit of output. AVC can be computed by dividing the TVC by total units of output.

AVC = TVC / Q

OUTPUT

COST OF PRODUCTION

AVERAGE COST or AVERAGE TOTAL COST

AC refers to cost per unit of output. AC is also known as the unit cost since it is the cost per unit of output produced.

ATC = AFC + AVC

OUTPUT

COST OF PRODUCTION

AAC

B

MARGINAL COST

Marginal cost may be defined as the net addition to the total cost as one more unit of output is produced. In other words it implies additional cost incurred to produced an additional unit.

MC n = TC n – TC n-1

COST OUTPUT RELATIONSHIP IN LONG RUN

Long run is defined as a period of time where adjustments to changed conditions are complete.

In long run the distinction between fixed and variable costs in the total cost of production will disappear in the long run.

LACSAC 1 SAC 2

M1

L1 L2

M2

OUTPUT

COST

OF

PRODUCTION

IMPORTANT FEATURES OF LONG RUN AC CURVES

Tangent curve.

Envelope curve.

Flatter U- shaped or dish – shaped curve.

Planning curve.

Minimum point of LAC curve should be always lower than the minimum point of SAC curve.