Module Name MANAGERIAL ECONOMICS

Unit No 2

Topic PRODUCTION AND PRODUCTION FUNCTION

INTRODUCTION TO THEORY OF PRODUCTION

Whatever business firms think, their basic motive is to achieve optimum efficiency of production or minimizing cost for a given production. In fact, the survival of a business concern in such a scenario of competitive market depends upon the ability of the business manager to produce it at a lower and competitive cost. After going through demand forecasting and measurement, we now turn our attention to the economic problems that are faced by the managers in organizing and planning the firm’s production and salient features of services. The fundamental production relationships also provide us with a basis for the study of costs. Once a manager comes to know about the physical relationships between productive services and output, cost functions can be derived from production functions when market prices of the productive services are given.

Managerial Questions:

1. Whether to produce or shut down?2. How much to produce?3. What input combination to use?4. What type of technology to use?

The theory of production gives a theoretical answer to these questions through abstract models built under hypothetical conditions. The production theory may not provide solutions to the real life problems. But it does provide tools and techniques to analyze the real life production conditions and to find solutions to the practical business problems. The theory of production deals with quantitative relationships i.e. technical and technological relations between inputs and outputs.

MEANING

In general sense the conversion of inputs into outputs is known as production. The inputs are processed, converted or transferred into output (goods or services).

In managerial sense, production process may take a variety of forms other than manufacturing. For example, transporting a commodity in its original form from one place to another where it can be consumed or used in the process of production is production. Besides,

ProcessInput Output

production process does not only involve physical conversion of raw material into tangible goods. Some kinds of production involve an intangible input to produce an intangible output. For example, in the production of legal, medical, social and consultancy services, both inputs and outputs are intangible; lawyers, doctors, social workers, consultancy, musicians, orchestra players, ‘bar girls’, etc, are all engaged in producing intangible goods.

An input is a good or service that goes into the process of production. In the words of Baumol, “An input is simply anything which the firm buys for use in its production or other processes”. An Output is any good or service that comes out of production process.

While the economists have classified inputs as labour, capital, land, raw materials and entrepreneurship. Technology and time are also treated as inputs in the modern concept of production.

INPUTS

The production function requires variety of inputs depending on the nature of products and services. And thus the economists have classified inputs into:

1. Fixed Inputs: in economic sense a fixed input is the one whose supply is inelastic in short run and users together cannot buy more of it in the short run. In technical sense, a fixed factor is hat which stays constant for a minimum or a certain level of output.

2. Variable Inputs: In short run the supply of a variable input is elastic and users can apply such factors in a larger quantity. Technically, such input is the one which changes with the change in output.

In long- run, all inputs are variable.

LONG-RUN AND SHORT-RUN

The reference periods in respect of time in production are known as long run and short run. The short-run refers to a period of time in which the supply of certain inputs is fixed or is inelastic. In the short-run therefore, production of a commodity can be increased by increasing the use of only variable inputs like labour and raw materials.

The long run refers to a period of time in which the supply of all inputs is elastic, but not enough to permit a change in technology. That is, in the long run, all the inputs are variable. Therefore, in the long-run, production of a commodity can be increased by employing more of both variable and fixed inputs.

The economists use another term i.e., very long run which refers to a period in which the technology of production function also changes. The technological advances result in a larger output from a given quantity of inputs per unit of time.

PRODUCTION FUCTION

Production function is a mathematical presentation of input-output relationship. It states the technological relationship between inputs and outputs in the form of an equation, a table or a

graph. In its general form, it specifies the inputs on which depends the production of a commodity or service. In specific form, it states the quantitative relationships between inputs and outputs. Besides, the production function represents the technology of a firm, of an industry or of the economy as a whole. A production function may take the form of a schedule or a table, a graphed line or curve, an algebraic equation or a mathematical model. But each of these forms of a production function can be converted into its other forms.

A real life production function is generally very complex. It includes a wide range of inputs, viz., land and building, labour including manual labour, engineering staff and managers, capital, raw material, time and technology. All these variables enter the actual production function of a firm. The long-run production function is generally expressed as:

Q=f (LB, L, K, M, T, t)

Where LB = land and building, L = labour, M = raw materials, T = technology and t = time.

The economists have however reduced the number of input variables used in production function to only two, i.e. capital (K) and labour (L), for the sake of convenience and simplicity in the analysis of input-output relations. A production function with two variable inputs, K and L, is expressed as

Q = f (L, K)

The reasons for excluding other inputs are following:

Land and building (LB), as inputs, are constant for the economy as a whole, and hence they do not enter into the aggregate production function. However, land and building are not a constant variable for an individual firm or industry. In the case of individual firms, land and building are lumped with ‘capital’.

In case of ‘raw materials’ it has been observed that this input ‘bears a constant relation to output at all levels of production’. For example, cloth bears a constant relation to the number of garments. Similarly, for a given size of a house, the quantity of brick, cement, steel etc. Remains constant, irrespective of number of houses constructed.

TYPES OF PRODUCTION FUNCTIONS

1. Linear Production Function: A production function that assumes a perfect linear relationship between inputs & total output

Leontief Production Function: A production function that assumes that inputs are used in fixed proportions

Cobb-Douglas Production Function: A production function that assumes some degree of substitutability between inputs

INPUTS AND OUTPUTS FOR BANK

The structure of the banking industry has undergone sweeping changes in the past two decades. In response to heightened competition from non-bank financial firms enabled by technological progress among other factors, banks have been expanding both the scale and scope of their operations, largely through consolidations. This merger wave coincides with extensive deregulation, which has removed restrictions on product offerings and interstate banking. The estimation of bank productivity and returns to scale has broad practical applications and has important policy implications. The Banking Sector is characterized by multiple inputs and outputs that are associated with various attributes, such as different types of deposits, loans, number of accounts, classes of employees and location of branches. In the aforementioned context we define productivity as a concept that involves the transformation of resources into final goods and services. Production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations of inputs. It indicates the highest output that a firm can produce for every specified combination of inputs.

This section describes the general approach taken for the analysis of the Production function of the Public Sector Banks (PSBs) in India. A bank for its operation takes several inputs and generates several outputs. Various examples for typical inputs are

1) Employees2) Deposits3) Capital for operation4) Reserves & surplus5) Number of branches6) Number of ATMs, etc.

Whereas output includes:

1) Loan (advances)2) Interest income3) Disbursement of loan or credit

For the Banking Sector there are few variables which are clearly treated as input variables and output (production) variables. For Example banks include Labour and capital as input variables and Interest Income as output variables. But there are variables like Deposits which are ambiguous in their treatment as either input or output. It is input because to disburse loan which is an output the bank requires deposits. It is this deposit which is finally disbursed as loan. However, Deposit is treated as Output because the performance of a Bank is measured among other parameters by how much Deposit it has been able to generate in a fiscal year.

SHORT-RUN LAWS OF PRODUCTION

The short term, input-output relations are learned with one variable input (labour), other inputs held constant. The laws of production under these conditions are called “Laws of Variable Proportions” or “Laws of Returns to a Variable Input”.

Law of Diminishing Returns: This law is also known as ‘Law of Variable Proportions’’. This law states that when more and more units of a variable input are used with a given quantity of fixed inputs, the total output may initially increase at an increasing rate and then at a constant rate, but it will eventually increase at a diminishing rates. That is, the marginal increase in total output decreases eventually when additional units of a variable factor are used, given quantity of fixed factors.

The law of diminishing returns is based on the following assumptions:

(1) Only one factor is variable while others are held constant.

(2) All units of the variable factor are homogeneous.

(3) There is no change in technology.

(4) It is possible to vary the proportions in which different inputs are combined.

(5) It assumes a short-run situation, for in the long-run all factors are variable.

(6) The product is measured in physical units, i.e., in quintals, tonnes, etc. The use of money in measuring the product may show increasing rather than decreasing returns if the price of the product rises, even though the output might have declined.

STAGES OF PRODUCTION FUNCTION

Given these assumptions, the table and graph illustrate the law, where on the fixed input land of 4 acres, units of the variable input labour are employed and the resultant output is obtained. The production function is revealed in the first two columns. The average product and marginal product columns are derived from the total product column.

The average product per worker is obtained by dividing column (2) by a corresponding unit in column (1). The marginal product is the addition to total product by employing an extra worker. 3 workers produce 36 units and 4 produce 48 units. Thus the marginal product is 12 i.e., (48-36) units.

An analysis of the Table shows that the total, average and marginal products increase at first, reach a maximum and then start declining. The total product reaches its maximum when 7 units of labour are used and then it declines. The average product continues to rise till the 4th unit while the marginal product reaches its maximum at the 3rd unit of labour, then they also fall. It should be noted that the point of falling output is not the same for total, average and marginal product.

The marginal product starts declining first, the average product following it and the total product is the last to fall. This observation points out that the tendency to diminishing returns is ultimately found in the three productivity concepts.

The law of variable proportions is presented diagrammatically in figure given below. The TP curve first rises at an increasing rate up to point A where its slope is the highest. From point A upwards, the total product increases at a diminishing rate till it reaches its highest point С and then it starts falling.

Point A where the tangent touches the TP curve is called the inflection point up to which the total product increases at an increasing rate and from where it starts increasing at a diminish-ing rate. The marginal product curve (MP) and the average product curve (AP) also rise with TP. The MP curve reaches its maximum point D when the slope of the TP curve is the maximum at point A.

The maximum point on the AP curves is E where it coincides with the MP curve. This point also coincides with point В on TP curve from where the total product starts a gradual rise. When the TP curve reaches its maximum point С the MP curve becomes zero at point F. When TP starts declining, the MP curve becomes negative. It is only when the total product is zero that the average product also becomes zero. The rising, the falling and the negative phases of the total, marginal and average products are in fact the different stages of the law of variable proportions which are discussed below

Stage-I: Increasing Returns:

In stage I the average product reaches the maximum and equals the marginal product when 4 workers are employed, as shown in the Table. This stage is portrayed in the figure from the

origin to point E where the MP curve reaches its maximum and the AP curve is still rising. In this stage, the TP curve also increases rapidly.

Thus this stage relates to increasing returns. Here land is too much in relation to the workers employed. It is, therefore, profitable for a producer to increase more workers to produce more and more output. It becomes cheaper to produce the additional output. Consequently, it would be foolish to stop producing more in this stage. Thus the producer will always expand through this stage I.

Stage-II: Diminishing Returns:

It is the most important stage of production. Stage II starts when at point E where the MP curve intersects the AP curve which is at the maximum. Then both continue to decline with AP above MP and the TP curve begins to increase at a decreasing rate till it reaches point C. At this point the MP curve becomes negative when the TP curve begins to decline, table 1 shows this stage when the workers are increased from 4 to 7 to cultivate the given land.

In figure 1, it lies between BE and CF. Here land is scarce and is used intensively. More and more workers are employed in order to have larger output. Thus the total product increases at a diminishing rate and the average and marginal product decline. This is the only stage in which production is feasible and profitable because in this stage the marginal productivity of labour, though positive, is diminishing but is non-negative.

Hence it is not correct to say that the law of variable proportions is another name for the law of diminishing returns. In fact, the law of diminishing returns is only one phase of the law of variable proportions.

The law of diminishing returns in this sense has been defined by Prof. Benham thus: “As the proportion of one factor in a combination of factors is increased, after a point, the average and marginal product of that factor will diminish.”

Stage-III: Negative Marginal Returns:

Production cannot take place in stage III either. For in this stage, total product starts declining and the marginal product becomes negative. The employment of the 8th worker actually causes a decrease in total output from 60 to 56 units and makes the marginal product minus 4. In the figure, this stage starts from the dotted line CF where the MP curve is below the A’-axis. Here the workers are too many in relation to the available land, making it absolutely impossible to cultivate it.

CONCLUSION

Causes of Increasing Returns:

1. The main reason for increasing returns in the first stage is that in the beginning the fixed factors are larger in quantity than the variable factor. When more units of the variable factor are applied to a fixed factor, the fixed factor is used more intensively and production increases rapidly.

2. In the beginning, the fixed factor cannot be put to the maximum use due to the non-applicability of sufficient units of the variable factor. But when units of the variable factor are applied in sufficient quantities, division of labour and specialization lead to per unit increase in production and the law of increasing returns operates.

3. Another reason for increasing returns is that the fixed factors are indivisible which means that they must be used in a fixed minimum size. When more units of the variable factor are applied on such a fixed factor, production increases more than proportionately. This points towards the law of increasing returns.

Causes of Diminishing Returns:

The distortion in the combination of factors may be either due to the increase in the proportion of one factor in relation to others or due to the scarcity of one in relation to other factors. In either case, diseconomies of production set in, which raise costs and reduce output.

For instance, if plant is expanded by installing more machines, it may become unwieldy. Entrepreneurial control and supervision become lax, and diminishing returns set in. Or, there may arise scarcity of trained labour or raw material that leads to diminution in output.

In fact, it is the scarcity of one factor in relation to other factors which is the root cause of the law of diminishing returns. The element of scarcity is found in factors because they cannot be substituted for one another.

The Best Stage of Production:

In stage I, when production takes place to the left of point E, the fixed factor is excess in relation to the variable factors which cannot be used optimally. To the right of point F, the variable input is used excessively in Stage III. Therefore, no producer will produce in this stage because the marginal production is negative.

Thus the first and third stages are of economic absurdity or economic nonsense. So production will always take place in the second stage in which total output of the firm increases at a diminishing rate and MP and AP are the maximum, then they start decreasing and production is optimum. This is the optimum and best stage of production.

LONG-RUN PRODUCTION CURVE

A situation where all inputs are subject to change in a case of long-run production function. As described that in short-run the fixed costs set an upper limit to the output because the additional units of variable factor, are not accompanied by a corresponding change in the fixed factors of production. Therefore, the contribution of the variable input declines. In long run such limitations does not exist. Under long-run all inputs are variable.

RETURNS TO SCALE

The percentage increase in output when all inputs vary in the same proportion is known as returns to scale. This relate to greater use of inputs maintaining the same technique of production. When scale to returns occurs, three alternative situations are possible to occur:

1. Constant Returns to Scale: Output increases in the same proportion as the increase in inputs.

2. Increasing Returns to Scale: Output increases in the greater proportion as the increase in inputs.

3. Decreasing Returns to Scale: Output increases in the lesser proportion as the increase in inputs.

Units Of Labour 

Units Of Capital % Increase In

Labour And Capital 

Total Product % Increase In

Total Product 

Returns To Scale

(Rs. '000)('00 Units)

(1) (2) (3) (4) (5) (6)1 100 - 100 0

Increasing2 200 100 220 1203 300 50 350 594 400 33.33 500 42.9

Constant5 500 25 625 256 600 20 750 207 700 16.67 860 14.67

Decreasing8 800 14.29 940 9.39 900 12.5 1000 6.4

In the above example the graph shows that spacing of the isoquants along a ray indicates whether returns are increasing, decreasing or constant.

This phenomenon can be explained by another example. For instance if all inputs are increased by a factor of 2, new values for output will be:

Double the previous output if there are constant re Twice the previous output if there are constant returns to scale (CRS)

Figure 10.15 Returns to Scale (P L Mehta, pg no:196)

Less than twice the previous output if there are decreasing returns to scale (DRS)

More than twice the previous output if there are increasing returns to scale (IRS)

Assuming that the factor costs are constant (that is, that the firm is a perfect competitor in all input markets), a firm experiencing constant returns will have constant long-run average costs, a firm experiencing decreasing returns will have increasing long-run average costs, and a firm experiencing increasing returns will have decreasing long-run average costs. However, this relationship breaks down if the firm does not face perfectly competitive factor markets (i.e., in this context, the price one pays for a good does depend on the amount purchased). For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range.

CONCLUSION:

For the management increasing, decreasing or constant returns to scale reflect changes in pro-duction efficiency that result from scaling up productive inputs. But returns to scale is strictly a production and cost concept. Management’s decision on what to produce and how much to produce must be based upon the demand for the product. Therefore, demand and other factors must also be considered in decision making.

CASE STUDY

A new bank branch specialized for “women only” is one of the first businesses to open in a small corner of a commercial building, still under construction. The branch has received rave reviews and has lines of customers waiting most times.

In the short run (next few months), what measures should the bank take to maximize its profit? Explain.

In the long run (next six months and beyond), how can it maximize its operations?

ASSESMENT

1. Does optimal use of an input (such as labour) mean maximizing average output (per unit of input)? Explain.

2. Explain the difference between diminishing returns and decreasing returns to scale.

3. Explain the nature and managerial uses of production function

Module Name MANAGERIAL ECONOMICS

Unit No 2

Topic COST CONCEPTS

INTRODUCTION

A managerial economist is always concerned about making a managerial decision. He considers various business proposals and evaluates them in terms of their costs and revenues. Therefore it is necessary to examine the ‘cost’ concept and its variations. A cost is directly related to output both in short-run and long-run. This section also explains the concept of ‘optimum size’.

MEANING AND DEFINATIONS

Cost refers to the type of expenditure incurred to produce a particular service. A sacrifice of some kind is required in all costs to acquire some benefit. Cost can be monetary or non-monetary, tangible or intangible, determined subjectively or objectively. The social costs like pollution, noise or traffic congestion add another dimension to the cost concept

Economists distinguish between direct costs and overhead costs, or to use the preferred terms, between variable costs and fixed costs. Variable or direct costs are those that vary with the level (or rate) of productive output. Variable costs are always relevant to the rate-of-production decision. Fixed or overhead costs are associated with the existence of the manager, the plant, and the equipment. Examples are contractual salaries and insurance premiums. They continue at the same levels or rates irrespective of the rate of production, even if it is zero. Once the plant has been put in place, these fixed or overhead costs are, so to speak, "sunk" costs, and sunk costs are not relevant to any rate-of-production decisions.

COST OUTPUT RELATIONSHIPS IN SHORT RUN

The short run is the period of time within which some contractual obligations associated with management, plant, and equipment are not alterable by changing the firm's managerial capacity or its scale of operations. The duration of the short run of course varies from organization to organization and situation to situation, and thus it can’t be specified in discrete terms.

Total output is a function of variable inputs and fixed inputs. Therefore, the total cost of production equals the fixed cost (the cost of the fixed inputs) plus the variable cost (the cost of variable inputs). Fixed costs are those costs that do not vary with output levels and variable costs are those costs that do vary with output levels. So, total cost can be written as;

TC = FC + VC

Marginal cost (MC) is the cost of expanding output by one unit. Since fixed cost has no impact on marginal cost, it can be written as,

MC = ∆VC/∆Q = ∆TC/∆Q

Average Total Cost (ATC) or Average Cost (AC) is the cost per unit of output, or average fixed cost (AFC) plus average variable cost (AVC).

This can be written as:

MC = ∆VC/∆Q = ∆TC/∆Q

The relationship between the production function and cost can be detected by looking at the relationship between either increasing returns to a factor and cost, or decreasing returns i.e. when the law of diminishing returns takes effect.

With increasing returns, output is increasing relative to input and variable cost and total cost will fall relative to output. On the other side with decreasing return and cost, output is decreasing relative to input and variable cost and total cost will rise relative to output.

In the case of per unit costs, AFC falls continuously and MC equals AVC and AC at their minimum. Minimum AVC occurs at a lower output than minimum AC.

Q FC TVC TC AFC AVC AC MC(1) (2) (3) (4) (5) (6) (7) (8)

0 10 0.00 10.00 - - - -1 10 5.15 15.15 10.00 5.15 15.15 5.152 10 8.80 18.80 5.00 4.40 9.40 3.653 10 11.25 21.25 3.33 3.75 7.08 2.454 10 12.80 22.80 2.50 3.20 5.70 1.555 10 13.75 23.75 2.00 2.75 4.75 0.956 10 14.40 24.40 1.67 2.40 4.07 0.657 10 15.05 25.05 1.43 2.15 3.58 0.658 10 16.00 26.00 1.25 2.00 3.25 0.959 10 17.55 27.55 1.11 1.95 3.06 1.5510 10 20.00 30.00 1.00 2.00 3.00 2.4511 10 23.65 33.65 0.91 2.15 3.06 3.6512 10 28.80 38.80 0.83 2.40 3.23 5.1513 10 35.75 45.75 0.77 2.75 3.52 6.9514 10 44.80 54.80 0.71 3.20 3.91 9.0515 10 56.25 66.25 0.67 3.75 4.42 11.4516 10 70.40 80.40 0.63 4.40 5.03 14.15

Decision making in short run:

1. If price is above average cost firm produces quantity at a profit.2. If price is between average cost and average variable cost firm produces quantity at a

loss.3. If price is below average variable cost, firm produces zero output, i.e. at a loss should

never produce if it is not covering even average variable costs in short-run.

COST OUTPUT RELATIONSHIPS IN LONG RUN

In the long run all factors of the firm's operations can be altered. All types’ costs are variable. It is seen that any long run consists of a sequence of short runs. All decisions affecting both the enterprise's scale and rate of operation are made in short-run settings, even those decisions affecting the long runs. The difference between the concepts of short-run and long-run are more useful in academic analysis than to operational decision making. Fixed costs, though irrelevant to rate-of-production decisions in the short run, become relevant to the scale-of-operations decisions of the long run.

In order to draw the long-run total cost curve, let’s begin with situation of a short-run. For instance, a firm has only one plant in short-run, its total cost curve is given as STC 1. Now if the firm adds up more plants over the time period one after the other, it would result in two or more short-run curves that are added to STC1. These curves are named as STC2, STC3, STC4. Now the LTC curve is drawn through the minimum points of STC1, STC2, STC3 and STC4, as shown in the figure by name of LTC curve corresponding to each STC.

Likewise, the long-run average cost curve is also derived by combining the short run average cost curves. In the graph detailed below the various SRAC curves combine and make up the long-run average cost curve (LRAC). A firm has a series of SAC curves, each having a lowest point. This curve is also known as ‘Envelope Curve’ or ‘Planning Curve’ as it illustrates and guides the entrepreneur in his plans to expand productions.

ASSESMENT

1. Explain why in the short run, cost curves are U-shaped?2. Explain why long-run average cost first falls, then rises. Why short-run average variable cost does

first falls, and then rises?

3. Examine the factors which explain why the average cost of producing a commodity declines with an expansion in the scale of production.

Figure 11.6 Long run total cost curve (P L Mehta, pg no:274)

Module Name MANAGERIAL ECONOMICS

Unit No 2

Topic ECONOMIES AND DISECONOMIES OF SCALE

INTRODUCTION TO ECONOMIES OF SCALE

The factors that cause the operation of the laws of returns the scale are grouped under economies and diseconomies of scale. Increasing returns to scale operates due to economies of scale and decreasing returns to scale operates due to diseconomies of scale where economies and diseconomies arise one after the other. Increasing returns to scale operates when economies of scale are more than the diseconomies of scale and returns to scale decreases when diseconomies overweight the economies of scale. Similarly when economies and diseconomies are in balance, returns to scale become constant.

DEFINATION AND MEANINGS

Economies of scale can be of two kinds:

1. Internal Economies2. External Economies

Internal economies are those which arise due to firm’s investment in increase of its plant size. While, external economies arise due to outside factors like improvement or deterioration in the environment in which the firm operates. The internal economics of scale relate to the long-run determine the shape of the long-run cost curve and the external economies affect the position of the long-run cost curves.

Internal Economies

The various types of internal economies are:

(1) Production economies(2) Marketing economies(3) Managerial economies(4) Transport and storage economies

1. Production economies: the economies from production arise from labour, fixed capital and inventory needs of the firm.

A. The rise in labour economies is due to the factors like division of labour economies as larger output allows division of labour which reduces cost by increasing specialization, by saving time and by providing conditions for inventories of a great number of machines. The technical personnel engaged in production tend to acquire significant experience from large-scale production.

This volume experience helps in higher productivity and therefore, reduce costs.

B. The technical economies of scale are associated with fixed capital, which includes machinery and equipment. Large-scale businesses can afford to invest in expensive and specialist capital machinery. The large size firms enjoy economies of large machines.

C. The role of inventories is to meet up the random changes made in put and output sides of the operations of the firm. It has been found that both input and output inventories increase at a rate lower than that of the increase in output. This can also be known as “massed resources”

2. Marketing Economies: The economies of marketing arise mainly due to two main reasons. Firstly, the advertising expenses are generally found to have increases less than proportionately with scale. Therefore, larger the output, smaller the advertising cost per unit. Secondly, the development and adoption of new models and designs involve considerable expenses in R&D. So whenever the output grows, the R&D expenditure spreads over input.

3. Managerial Economics: Larger the firm greater are the opportunities for the division of management tasks. The division of managerial tasks helps managers to specialize in their own areas of responsibility, thus leading to greater efficiency.

4. Transport and Storage Economics: Storage costs fall with the increase in the size of output.

Some other types of economies may be listed below because of which a firm obtain discounts due to its large size:

1. Lower rate material price due to bulk buying2. Lower cost of capital, as banks usually place greater faith in the large firms and,

therefore, change lower rate of interest3. Offers of lower rates for advertising to large firms because of their large-scale

advertising4. Lower transportation rates due to bulk transportation

EXTERNAL ECONOMIES OF SCALE

External economies of scale occur outside of a firm but within an industry. Thus, when an industry's scope of operations expand due to for example the creation of a better Transportation network, resulting in a decrease in cost for a company working within that industry, external economies of scale have been achieved. Another example is the development of research and development facilities in local universities that several businesses in an area can benefit from. Likewise, the relocation of component suppliers and other support businesses close to the centre of manufacturing are also an external cost saving.

DISECONOMIES OF SCALE

These are the result of the decreasing returns to scale. The major diseconomies that a firm can experience are:

1. Lack of Control- monitoring the productivity and the quality of output from thousands of employees in big companies is imperfect and costly - this links to the concept of the principal – agent problem – how best can managers assess the performance of their workforce when each of the stakeholders may have a different objective or motivation which can lead to stakeholder conflict?

2. Non-cooperation - workers in larger firms may feel a sense of alienation and subsequent loss of morale. If they do not consider themselves to be an integral part of the business, their productivity may fall leading to higher wastage and higher costs. Moreover it is argued that due to lack of personal touch the spirit in a large form is less than that in a small firm.

CONCLUSIONThe key to understanding Economies of Scale and Diseconomies of Scale is that the sources vary. A company needs to determine the net effect of its decisions affecting its efficiency, and not just focus on one particular source. Thus, while a decision to increase its scale of operations may result in decreasing the average cost of inputs (volume discounts), it could also give rise to diseconomies of scale if its subsequently widened distribution network is inefficient because not enough transport trucks were invested in as well. Thus, when making a strategic decision to expand, companies need to balance the effects of different sources of Economies of Scale and Diseconomies of Scale so that the average cost of all decisions made is lower, resulting in greater efficiency all around.

ASSESMENT

1. What is meant by economies of scale?2. Explain the various economies and diseconomies of scale?3. An automobile company recently expanded its annual production from 100 units to 150

units and also diversified its activity. Highlight the economies and diseconomies which the company may incur due to such expansion and diversification.

4. Do firms operate at optimum scale?

BIBLIOGRAPHY

1) Mehta, P. (2010). Managerial Economics Analysis, Problems and Cases. 16th ed. New Delhi: Sultan Chand & Sons, pp.210 - 246.

2) Pindyck, R., Rubinfeld, D. and Mehta, P. (2009). Microeconomics. 7th ed. Upper Saddle River, N.J.: Pearson Prentice Hall, pp.171 - 250.

3) Singh, K. and Bansal, M. (2011). Managerial economics. New Delhi: Mittal Publications, pp.121 - 146.

4) www.yourarticlelibrary.com