Theory of Production PDF

7 u n i t Theory of Production Learning Objectives After studying this unit, you will be able to: ll Know the meaning of production in economics ll Understand the various factors of production...

7 u n i t Theory of Production Learning Objectives After studying this unit, you will be able to: ll Know the meaning of production in economics ll Understand the various factors of production ll Understand the difference between short run and long run production function ll Have an insight into the laws of returns and returns to scale ll Grasp economies and diseconomies of scale Meaning of Production The main objective of production is to satisfy the demand for commodities and services of the community. Production is an organized activity of transforming inputs into outputs. For example, a sugar mill uses such inputs as labour, raw material such as sugarcane, and capital invested in machinery and factory building to produce sugar. This process of transforming inputs into output can be any one of the following: 1. Form utility: Changing the form of natural resources into finished products, for example, changing a log of wood into furniture. 2. Place utility: When a person transports a commodity from places of plenty to places of scarcity where the commodity will command value due to demand. For example, transporting apples from Himachal Pradesh to other states in India. 3. Time utility: By storing the commodities and offering at a future date. For example, canned food items and fruits. Production in economics means creation of economic utilities. It is an important economic activity. The process of growth or development consists in increasing the level of production in the economy. Productive activity indulged in for its own sake or for pleasure or as hobby is not produc- tion in economics. For example, singing for one’s own happiness or pleasure. Prof. Hicks defines production as activities for the satisfaction of other people’s wants through exchange. Anything that renders a help in the process of production is called factor of production. According to Prof. Benham, all goods and services that help in the process of production are called factors of production. The factors of production may be natural or man-made. Modern Economists have grouped them as Land, Labour, Capital, and Entrepreneur. A.105 M07_GENERAL_ECONOMI_7989_CH07.indd 105 8/7/2014 10:16:16 AM  A.106 l Theory of Production and Costs Factors of Production Land Land as a factor of production in Economics has a wider connotation than land in ordinary lan- guage. Apart from being the surface of the earth, the soil, or the ground, in Economics, it means all those things, animate or inanimate, which are given to us free by nature, which are helpful in production and are not capable of being produced by human agency. Thus, it includes the soil, its properties, natural elements such as air, heat, rainfall, sunshine, water above as well as below the surface of the earth, the various minerals, and numerous gifts of nature that the man puts to economic uses. Characteristics of land 1. Land is the free gift of nature and not man made one. The supply of land comes from the nature. No human effort or sacrifice was necessary originally to produce land. That is why land has no cost of production. Therefore, it is called original factor of production. 2. Rent is the price paid for the use of land. 3. According to Ricardo, land has got original and indestructible powers. 4. Supply of land is fixed. Land is gift of nature. Its supply can be neither increased nor decreased at any human effort. Economists remark that land has no supply price. 5. Land lacks mobility: Land cannot be moved from one place to another. However, land can be put to different uses, that is, it can be used for the construction of buildings, factories, cultivation, and so on, and thus, it has mobility in use. 6. Land is heterogeneous and varies in quality. Land, like the other factors of production, differs from one another in nature, fertility, and productivity. Labour Labour is defined as ‘any exertion of mind or body undertaken partly or wholly with a view of some good other than the pleasure directly derived from the work’. Any amount of Nature’s gift will be of little use to man unless he expands some effort on them. Therefore, labour refers to mental or physical exertion of human mind or body with a view to get monetary reward. Characteristics of labour The following are the characteristics of labour: 1. Human element is involved in labour. We should not look at labour merely as an agent of pro- duction as men, women, and children are involved in it. 2. Labour can be supplied only in person. That is why we may say labour is inseparable from the labourer. 3. Labour is perishable. The labour power if not used once is lost for ever. It cannot be regained. The labour cannot be stored and used later. 4. Labour has weak bargaining power. Usually, labourers have no reserve and therefore, com- pelled to accept low wages rather than refuse employment. However, the development of the trade union has considerably improved the bargaining power of the labour in recent times. 5. Labour is highly mobile. Mobility of labour has increased due to development of auto- matic machinery, spread of general education, and cheap transport have greatly influenced mobility of labour. M07_GENERAL_ECONOMI_7989_CH07.indd 106 8/7/2014 10:16:16 AM  Theory of Production l A.107 6. Labour is heterogeneous. The efficiency of labour varies from person to person. It may depend upon the physical strength, motivation, aptitude, education, skill, and so on. 7. Supply of labour depends upon the size and composition of population. The basic source of labour supply is population and the composition of people in the age of group of working population. Thus, labour is called original factor of production. 8. Wage is the price paid for use of labour. 9. Backward bending supply curve of labour. Another important characteristic feature of labour is the peculiarity in its supply. The labourer has to make a choice between the hours of labour and hours of leisure. The supply of labour and wage rate is directly related. Generally, as the wage rate rises, the labourer tends to increase the supply of labour by reducing the hours of leisure. However, at very high levels of wage, the labourer reduces the supply of labour and increases the hours of leisure since with the available wage income, he can have a comfortable level of living. Hence, the supply curve of labour is back- ward bending. It is illustrated in Figure 7.1. S W2 Wage W1 H Rate 0 L2 L1 Supply of Labour (Hours or Work) Figure 7.1 In Figure 7.1, the supply curve is positively sloped up to the point H on it indicating the rise in wage rate up to the level of W1 is accompanied by increase in the supply of labour up to L1. Buy beyond W1 wage rate; the labourers reduce the supply of labour with every rise in wage rate. Thus, the rise in wage rate from W1 to W2 is accompanied by the decline in the supply of labour from L1 to L2. Thus, substitution effect becomes stronger than income effect at high levels of wage. Division of Labour Division of labour refers to a scheme of dividing a given productive activity into different segments and employing different workers. It results in greater specialization. As a result, the efficiency of individual worker is improved. Adam Smith has originally given this concept of division of labour. He has given the classical example of pin making industry, having 18 different operations in manu- facturing pins and employing different sets of labourers. M07_GENERAL_ECONOMI_7989_CH07.indd 107 8/7/2014 10:16:17 AM  A.108 l Theory of Production and Costs Advantages The following are the advantages of division of labour: 1. Large-scale production: The division of labour helps to increase the production. This is very clear from the example of pin manufacturing cited by Adam Smith. According to him, a single man can produce at the most only 20 pins in a day. However, by division of labour, he can pro- duce 4,800 pins a day. 2. Good quality of the product: Since each process of the product is specialized by an expert worker, the quality of the product will be very good. 3. Skill formation: As the labourers do the same work repeatedly and continuously, they get mas- tery over the work. This increases their skill and dexterity. 4. Saving of time and tools: When goods are produced with the help of division of labour, much time is saved, and since the labourers are entrusted with a particular type of work, there is no possibility to abuse or misuse the tools and implements. 5. Mechanization: Division of labour makes mechanization possible. In turn, the type of division of labour depends a great deal on the degree of mechanization. 6. Inventions: The division of labour promotes inventions in the methods and techniques of pro- duction. The workers with their mastery over their part of work can easily devise new means and techniques of production. 7. Benefits of economies of scale: It is possible to reap the benefits of economies of scale as a result of availability of both internal and external economies. They are obtained from mecha- nized production, specialization, and division of labour. Demerits 1. Monotony: Division of labour may lead to monotony and boredom because each individual worker performs only a small part of the job which he keeps on doing again and cannot identify his work with the complete job. 2. Unemployment: If a person loses his job, then it is very difficult to get alternative employment due to his narrow specialization. 3. No scope for promotion as job experience is limited to a particular operation in a firm. Factors limiting division of labour 1. Extent of the market: Adam Smith says ‘The division of labour is limited by the extent of mar- ket’. This means that division of labour depends upon the market. If the market is large, then specialization of labour is profitable. On the other hand, if the market is small, specialization does not pay, as there may not be enough business for specialization. 2. Nature of demand: The extent of division of labour varies with the nature of demand. The demand for the product may be elastic or inelastic. If the specialized product enjoys inelastic demand, then division of labour is highly profitable. However, when the demand is elastic, divi- sion of labour becomes very much limited. 3. Availability of capital: The division of labour is also limited by the availability of capital. If there is scarcity of capital, then the process of division of labour may not be given effect to, and even if it is, it is technically desirable to do so. 4. Labour problems: The labour unions may demand more wages which may increase the cost instead of reducing it. 5. Diminishing returns: The operation of the Law of Diminishing Returns is another limiting fac- tor to the division of labour. The practice of division of labour may be affected when the law M07_GENERAL_ECONOMI_7989_CH07.indd 108 8/7/2014 10:16:17 AM  Theory of Production l A.109 of diminishing returns sets in. It makes the cost of production very high and renders division of labour unprofitable. Capital The term ‘capital’ has been interpreted in many ways by Economists. Primarily, capital is not an original factor of production such as land or labour. It is a derived factor. Hence, capital has been defined as the produced means of production. It means that capital has been created by man. Cap- ital can also be described as ‘the man-made instruments of production’. Capital, thus, consists of those physical assets which are produced by men so that they can be used in future for produc- tion. Machines, tools, instruments are examples of capital. This interpretation of capital stressed the physical nature of capital. However, in recent years, apart from physical capital, the concept of human capital has been stressed as a tool of economic development. Features of capital 1. Capital is income yielding 2. Capital is non-permanent 3. Interest is the reward for capital 4. Capital is heterogeneous 5. Capital has high degree of mobility 6. Capital and wealth do not mean the same Capital and Wealth Capital, as a factor of production, is commonly defined as that part of wealth (excluding land and other free gifts of nature) which can be used for further production. In the language of Bohm- Bawerk, Capital is, ‘produced means of production’, that is, those ‘means of production’ which have been produced by labour (e.g., tools, machines, buildings, etc.). 1. Goods that are used for consumption may form part of wealth, but not part of capital. 2. Even among the goods used for further production, land (may be part of wealth), is not part of capital as it is free gift of nature (not ‘man-made’). From the foregoing analysis, it is seen that all capital is wealth, but all wealth is not capital. In other words, that part of wealth which is used for further production is called as capital. That part of wealth which is not used for further production but used for consumption is not capital. That is why Bohm Bawerk has defined capital as, ‘produced means of further production’. Classification of capital 1. Fixed capital is that which exists in a durable shape and renders a series of services over a period of time, for example, tools, machines, and so on. 2. Circulating Capital is another form of capital which performs its function in production in a single use and not available for further use, for example, seeds, raw materials, and so on. 3. Real Capital refers to physical goods such as building, plant, machinery, and so on. 4. Human skill and ability is called human capital because a good deal of investment has gone into creation of these abilities in man. 5. Tangible capital can be perceived by senses (e.g., Machinery), whereas intangible capital is in the form of certain rights and benefits that cannot be perceived by senses (e.g., goodwill, patent rights, etc.). M07_GENERAL_ECONOMI_7989_CH07.indd 109 8/7/2014 10:16:17 AM  A.110 l Theory of Production and Costs 6. Individual capital is the personal property owned by an individual or a group of individuals. 7. Social capital belongs to the society as a whole in the form of roads, bridges and so on. Capital formation Capital formation has been defined by Benham as ‘the amount which a community adds to its capi- tal during a period is known as the amount of its investment or capital formation during the period’. Thus, capital formation is investment in the real sense. It refers to the creation of capital assets which can increase the productivity in a country. Capital formation or capital accumulation is one of the important factors that influence the economic growth of a country. One main reason for the high rate of economic growth of the developed nations of today such as the US is the high level of capital formation. However, in most of the underdeveloped countries, the rate of economic growth is low mainly because there is low level of capital formulation. Since capital formation is low, the productivity of labour in those countries is low. Therefore, incomes are low, savings are low, and capital formation is low. Stages of capital formation There are mainly three stages of capital formation which are as follows: 1. Creation of savings: The basic factor on which formation of capital depends is the ability to save. The ability to save depends upon the income of the individual. Higher incomes are generally followed by higher savings. This is because with an increase in income the propensity to consume comes down, and the propensity to save increases. This is true not only for an individual but also for the economy as a whole. A rich country has greater ability to save and thereby can get richer quickly compared to a poor country which has no ability to save and therefore, has limited capacity for growth. It is not only the ability to save but willingness to save which counts a great deal. Willing- ness depends upon the individual’s concern about his future as well as upon the social set-up in which he lives. If an individual is farsighted and wants to make his future secure, then he will save more. Moreover, the government can enforce compulsory savings on the people by imposing taxes. 2. Mobilization of savings: It is not enough that people save money; what is required is that saved money enters into circulation and facilitates the process by capital formation. There should be a wide spread network of banking and other financial institutions to collect public sav- ings and take them to prospective investors. In this process, the state has a very important and positive role to play both in generating savings through various physical and monetary incentives and channelization of the savings towards priority needs of the community so that there is not only the capital generation but socially beneficial type of capital formation. There are three main sources of savings in an economy. They are household savings, corporate savings and government savings. 3. Conversion of savings into investment: The process of capital formation gets completed only when the real savings get converted into real capital assets. An economy should have a entre- preneurial class which is prepared to bear the risk of business and invest savings in productive avenues so as to create new capital assets. Private investments are induced investments (made when Marginal Efficiency of (MEC), that is, expected profitability from investment is greater than ‘r’ (rate of interest). Public investments are autonomous. M07_GENERAL_ECONOMI_7989_CH07.indd 110 8/7/2014 10:16:17 AM  Theory of Production l A.111 Entrepreneur Entrepreneur is an important factor of production which mobilizes other factors of production, combines them in the right proportion, then initiates the process of production and bears the risk involved in it. He has also been called the organizer, the manager or the risk taker. However, in these days of specialization, the task of manager or organizer has become different from that of the entrepreneur. While organization and management involves in decision-making of routine and non-routine types, the task of the entrepreneur is to initiate production work and to bear the risk involved in it. Functions of an entrepreneur 1. Initiating a business enterprise and resource co-ordination: The most important function of an entrepreneur is to initiate a business enterprise. There are various factors such as land, labour, and capital, which are employed in production process. It is another task of entre- preneur to coordinate these factor inputs in the production process. While payments to other factors of production are fixed on a contractual basis, such as labour at fixed rate of wages, land or factory building at a fixed rent for its use, and capital at a fixed rate of interest, the entrepreneur is rewarded by way of profits for all his efforts of co-ordination and risk taking after meeting all the payments. 2. Risk bearing or uncertainty bearing: The success and survival of business lies with the entrepreneur. What is planned and anticipated by the entrepreneur may not come true and the actual course of events may differ from what was anticipated and planned. The economy is dynamic and changes occur every day. The demand for a commodity, the cost structure, fashions and tastes of the people, and government’s policy regarding taxation, credit, interest rate, and so on, may change. All these changes bring about changes in the cost and demand conditions of a business firm. It may happen that as a result of certain broad changes which were not anticipated by the entrepreneur the firm has to incur heavy losses. Thus, the entrepreneur has to bear these financial risks. Apart from financial risk, the entrepreneur also faces technological risks that arise due to the inventions and improvement in techniques of production, making the existing technique and machines obsolete. The entrepreneur has to assess and bear the risks. These risks are different from the risks such as risks of fire, theft, burglary, and so on, which can be insured against. These risks which cannot be insured are also called uncertainties and the entrepreneur earns profits because he bears uncertainty in a dynamic economy where changes occur every day. 3. Innovations: One of the important functions of an entrepreneur is to introduce innovations. Innovations in a very broad sense include the introduction of new or improved production meth- ods, utilization of new or improved source of raw materials, adoption of new or improved forms of organization, introduction of a new or improved product and opening of new or improved markets. According to Schumpeter, the task of the entrepreneur is to continuously introduce new innovations. 4. Profit is the reward for entrepreneur: The profit is the reward for an entrepreneur. It is the acid test of any entrepreneurial ability. The possibility of success and large profits induces people to undertake risks. It is for the function of risk taking that the entrepreneur receives ‘pure profits’. However, profit is not fixed. He may earn profits, or incur losses. Other factors get their pay- ment irrespective of whether the entrepreneur makes profits or losses. In modern times, functions of entrepreneur are delegated to salaried managers. M07_GENERAL_ECONOMI_7989_CH07.indd 111 8/7/2014 10:16:17 AM  A.112 l Theory of Production and Costs Meaning of Production Function A production function expresses the functional relationship between combination of inputs and outputs. Production is the process in which the physical inputs are transformed into physical out- puts. The output is, thus, the function of inputs. The production function shows for a given state of technology and managerial ability, the maximum rates of output that can be obtained from differ- ent combinations of productive factors during the period of time. In short, production function is a catalogue of output possibilities. The production function can be algebraically expressed in an equation in which the output is the dependent variable and inputs are the independent variables. The equation can be expressed as: q = f (a, b, c, d, …, n) Where ‘q’ stands for the rate of output of given commodity. a, b, c, d, …, n are different factors and services used per unit of time. In Economic theory, production analysis considers two types of input-output relationships. 1. The input-output relationship when certain inputs are kept fixed and other inputs are made variable is studied by the law of variable proportions. 2. If all inputs are variable, then it is studied by returns to scale. Before analysing the above two laws, it is important to know the distinction between, total prod- uct, average product and marginal product. Total Product Total product refers to the total output of a commodity produced by the combination of fixed factors and variable factor. As the number of variable inputs increases, the fixed factor remain- ing constant—the total output will increase but in a disproportionate manner. It may be observed from the table (vide table in Page 114) that the total product increases, first at an increasing rate — from 10 to 22 and from 22 to 36. Later, total output increases but at a diminishing rate from 48 to 55, from 55 to 60, and so on. The total product curve rises rapidly at first and then more slowly, until it reaches maximum and later it decreases. Thus, it is the sum of marginal products. Average Product The average product refers to the output of one variable input. It is calculated by dividing the total output by the number of variable inputs. If two workers produce 22 units of output, then the average output of one worker is 11 units. And if three workers produce 36 units, then the average output per worker is 12 units of output (vide table in Page 114). The formula for average product is Total product Average product = Number of variable factor units Marginal Product The marginal product, on the other hand, refers to the additional output, that is, addition to the total output from the use of an additional unit of variable input (worker). For instance, if two work- ers produce 22 units of output and if three workers produce 36 units, the marginal output of the third worker is 14 units. If four workers produce 48 units and five workers produce 55 units, then M07_GENERAL_ECONOMI_7989_CH07.indd 112 8/7/2014 10:16:17 AM  Theory of Production l A.113 the marginal product is seven units—this is the addition to the total output by the use of the fifth worker (vide table in Page 114). The formula for marginal product is Marginal product = TPn - TPn-1 in which TP is total product, ‘n’ is the number of variable factor units. Short period production function In short period, only one factor is variable and other factors are fixed and so the following three laws of returns are in operation: 1. Law of increasing returns: Marginal product increases and the total product increases at more than proportionate rate. 2. Law of diminishing returns: Marginal product declines and the total product increases at less than proportionate rate. 3. Law of negative returns: Marginal product is negative and the total product will be declining. Law of Variable Proportion The Law of Variable proportions is the fundamental law of production. Laws of Returns operate in a sequence. First there will be increasing returns, followed by diminishing returns. Beyond this stage, there can be negative returns. In the theory of production, the law which examines the relationship between one variable fac- tor and keeping the quantities of other factors fixed is called the law of variable proportions. Under this law, we study the effects on output of variable factor-proportions, this has come to be known as the law of variable proportions. The law is stated as, ‘As the proportion of one factor in a combination of factors is increased, after a point, first the marginal and then the average product of that factor will diminish’. In other words, law of variable proportions refers to the behaviour of output, as the quantity of one factor is increased, keeping the quantity of other factors fixed, and furthermore, it states that the marginal product and average product will eventually decline. Assumptions of the law The law is based upon the following assumption: 1. The state of technology remains constant. If there is any improvement in technology, then the average and marginal output will not decrease but increase. 2. Only one factor of input is made variable and other factors are kept constant. This law does not apply to those cases where the factors must be used in rigidly fixed proportion. 3. All units of the variable factor are homogenous and divisible. Hence, there is substitution between factors. 4. The law refers to the quantity of output and not the value of output. Three stages of the law The behaviour of the output when the varying quantity of one factor is combined with a fixed quantity of the other can be divided into three distinct stages- Increasing Returns, Diminishing Returns, and Negative Returns. The three stages can be better understood Table 7.2 and Figure 7.2. M07_GENERAL_ECONOMI_7989_CH07.indd 113 8/7/2014 10:16:17 AM  A.114 l Theory of Production and Costs TABLE 7.1 Product Schedule Fixed Factor Variable Total Product Average Product Marginal Product (Machine) Factor (in Units) (in Units) (in Units) (Labour) 1+ 1 10 10 10 1+ 2 22 11 12 1+ 3 36 12 14 1+ 4 48 12 12 1+ 5 55 11 7 1+ 6 60 10 5 1+ 7 63 9 3 1+ 8 64 8 1 1+ 9 64 7.1 0 1+ 10 63 6.3 -1 I Stage II Stage H III Stage TP, MP, and AP TP P S AP 0 N M MP Variable Factor Figure 7.2 1. Stage I—Operation of increasing returns: In this stage, the total product increases at an increasing rate. The Total Product curve (TP) increases sharply up to the point ‘P’, that is, where the Marginal Product (MP) is at the maximum. Afterward, that is, beyond ‘P’ the total product curve increases at a diminishing rate, as the marginal product falls, but is positive. The point ‘P’ where the total product stops increasing at an increasing rate and starts increasing at a diminishing rate is called the point of inflexion. At this point, the marginal product is at the maximum. Therefore, Stage I refers to the increasing returns where the total product, the marginal product and average product are increasing. It means operation of the Increasing Return in Stage I. 2. Stage II—Operation of diminishing returns: In the beginning of second stage, at point ‘S’ Average Product is equal to Marginal Product, MP curve cuts AP curve at its maximum point. During the second stage, Diminishing Returns operates. In this stage, Total Product continues to increase, but at a diminishing rate until it reaches the point ‘H’ where it completely stops to increase any further. At this second stage, the marginal product and average products are declining but are positive. M07_GENERAL_ECONOMI_7989_CH07.indd 114 8/7/2014 10:16:18 AM  Theory of Production l A.115 3. Stage III—Operation of negative returns: In the beginning of third stage, at point ‘H’, the total product is at the maximum and the marginal product is zero. MP is cutting the ‘X’ axis. In this stage, the total product declines and therefore, the TP curve slopes downwards. The marginal product becomes negative and TP declines. This stage is called the Negative Returns Stage. Thus, the total product marginal product and average product pass through three phases, namely increasing, diminishing and negative returns. The law of variable proportion is nothing but the combination of the law of increasing and diminishing returns. Now, the question is in which stage the producer will seek to produce the commodities. Being rational, a producer will not come to the third stage where the marginal product becomes nega- tive. He will not produce to get negative returns. The producer will also not choose to produce in Stage I, as he will not be making the best use of the fixed factor and he will not be utilizing fully the opportunities of increasing production by increasing quantity of the variable factor whose average product continues to rise throughout the Stage I. Therefore, the rational producer will not stop in Stage I, but expand further. Hence, the producer will produce in Stage II where the total product leads to the maximum. At this particular point of the second stage, the producer's decision to pro- duce depends upon the prices of factors. The Stage II represents the range of rational production. The relationship between AP and MP can be summarized as follows: 1. When AP rises, as a result of an increase in the quantity of variable input, MP is more than the AP. 2. When AP is maximum, MP is equal to AP. In other words, MP curve cuts the AP curve at its maximum. 3. When AP falls, MP is less than the AP. Long Period Production Function—Returns to Scale The concept of variable proportion is a short run phenomenon, as in this period fixed factors can- not be changed and all factors cannot be changed. On the other hand, in the long term, all factors can be changed or made variable, when we study, the changes in output when all factors or inputs are changed, returns to scale operate. An increase in the scale means that all inputs or factors are increased in the same proportion. In variable proportions, the co-operating factors may be increased or decreased and one factor, for example, land in agriculture or machinery in industry, remains constant, so that the changes in proportion among the factors result in certain changes in output. In Returns to Scale, all the necessary factors of production are increased or decreased to the same extent and the proportion among the factors remains the same. This is known as changing the scale of production. Under the returns scale, there are three phases, namely increasing returns to scale, constant returns to scale, and diminishing returns to scale. Increasing returns to scale Under this, when factor proportions are increased in a particular percentage (say 10%), the output increases more than proportionate increase in input (Output > 10%). In increasing returns to scale, the economies are greater than diseconomies. Constant returns to scale Under this, when factor proportions are increased in a particular percentage (say 10%), the output increases equal to the proportionate increase in input (Output = 10%). In constant returns to scale, the economies are equal diseconomies. M07_GENERAL_ECONOMI_7989_CH07.indd 115 8/7/2014 10:16:18 AM  A.116 l Theory of Production and Costs Diminishing returns to scale Under this, when factor proportions are increased in a particular percentage (say 10%), the output increases less than proportionate increase in input (Output < 10%). In diminishing returns to scale, the diseconomies are greater than economies. Returns to scale in terms of cost conditions Returns to scale can be expressed in terms of cost conditions: 1. Increasing Returns to scale means decreasing Cost 2. Constant Returns to scale means Constant Cost 3. Diminishing Returns to scale means Increasing Cost Product optimization—theory of isoquants A producer’s equilibrium means product or output maximization with least cost combination of factors. This is illustrated with the help of isoquants (IQs) and isocost lines. Isoquants Isoquants are also called equal product curves and production indifference curves. IQs are similar to indifference curves in consumer behaviour theory. An IQ shows various combinations of two factors say X and Y, which will secure the same level of output. This is shown by the following IQ schedule. Table 7.2 Isoquant Schedule Factor Factor X Factor Output Units MRTS Combination A 4 25 100 – B 5 20 100 1:5 C 6 16 100 1:4 D 7 13 100 1:3 E 8 11 100 1:2 Isoquant is derived by plotting the above IQ schedule as shown in Figure 7.3. 25 A Y Factor 20 B C 15 D 10 E IQ (100 Units) 5 0 2 4 6 8 X Factor Figure 7.3 M07_GENERAL_ECONOMI_7989_CH07.indd 116 8/7/2014 10:16:18 AM  Theory of Production l A.117 Isoquants above is similar to indifference curves. The only difference is that in the case of indifference curve, we do not quantify the amount of satisfaction. However, in the case of IQ, we can easily quantify the output. The properties of IQ are similar to indifference curves. 1. IQ slopes downward from left to right. 2. IQ is convex to the point of origin due to diminishing Marginal Rate of Technical Substitution (MRTS; see table 7.2 given above). 3. Higher IQ represents higher level of output. 4. One IQ will not intersect another IQ because each IQ represents a particular level of output. Producer’s equilibrium and least cost combination of factors Producer’s equilibrium is based on the following assumptions: 1. Technological conditions are constant 2. Factors of production are combined in the most efficient manner Producer’s equilibrium is determined by using IQ line and isocost line. Derivation of isocost line Isocost line shows the ratio between the prices of X and Y factors as shown in Figure 7.4. Isocost Lines C B Y Factor A 0 A1 B1 C1 X Factor Figure 7.4 In Figure 7.4, AA1, BB1, and CC1 are isocost lines for various quantities of resources available to the producer. Let us assume that price of X factor is `100 and price of Y factor is `50. 1. If the producer has resources of `1,000, then he can buy 10 units of X factor or 20 units of Y factor. This is illustrated by isocost line AA1 in the diagram. 2. If the producer has resources of `2000, then he can buy 20 units of X factor or 40 units of Y factor. This is illustrated by isocost line BB1 in the diagram. 3. If the producer has resources of `3000, then he can buy 30 units of X factor or 60 units of Y factor. This is illustrated by isocost line CC1 in the diagram. M07_GENERAL_ECONOMI_7989_CH07.indd 117 8/7/2014 10:16:18 AM  A.118 l Theory of Production and Costs Producer Equilibrium D P C Q Y Factor B A N R S T IQ (100 Units) 0 M A1 B1 C1 D1 X Factor Figure 7.5 In Figure 7.5, let us assume as follows: 1. Isocost line AA1 for given resources of `1,000 2. Isocost line BB1 for given resources of `2,000 3. Isocost line CC1 for given resources of `3,000 4. Isocost line DD1 for given resources of `4,000 From these situation, we find that points P and T are on isocost line DD1 representing a cost of `4,000 and output 100 units. Points Q and S are on isocost line CC1 representing `3,000 and output 100 units. However, point represents least cost combination of factors representing lowest cost of `2,000 for producing the same output of 100 units. Thus, in Figure 7.6, point R represents producer equilibrium at lowest cost of `2,000 to produce 100 units of output. The factor combination is OM units of X factor and ON units of Y factor. Economies of Scale Large scale production offers certain advantages which help in reducing the cost of production. Economies arising out of large scale production can be grouped under two categories, namely internal and external economies. Internal economies are those economies of production which accrue to the firm from within when it expands the output, so that the cost of production would come down considerably and place the firm in a better position to compete in the market. Econo- mies arise purely due to endogenous factors relating to efficiency of the entrepreneur or his mana- gerial talents or the type of machinery used or the marketing strategy adopted. These economies arise within the firm and help the firm only. On the other hand, external economies are the benefits accruing to each member firm of the industry as a result of the expansion of the industry. Internal Economies Internal economies are advantages available to a single firm independently due to it resources. These economies arise due to the technical superiority, managerial and marketing abilities and financial strength. These economies arise when a firm expands the scale of production. M07_GENERAL_ECONOMI_7989_CH07.indd 118 8/7/2014 10:16:18 AM  Theory of Production l A.119 The internal economies can be sub-divided into five categories: 1. Technical economies: A firm expanding its scale of production can enjoy distinct advan- tages on the technical side such as superior technique, increased dimensions and linked processes, and so on. (a) Large scale producers can introduce up-to-date machines and thereby increase the productivity of labour. Big machines can be continuously used and also to its full capacity only when large scale production is carried on. (b) Under technical economies, a large scale producer has the benefit arising out of experiments and research. He can have separate department conducting experiments and research to find out better technology so that the cost of production could be considerably brought down. (c) Utilization of by-products in large scale operation is another advantage. The large scale producer can start a subsidiary industry or to sell the product as raw materials to firms engaged in the pro- duction of goods using the raw materials. 2. Managerial economies: Large scale production gives the benefit of managerial special- ization by creating department entrusting to each of a particular item of work such as ‘purchase’, ‘stores’, ‘selling’, and so on. Furthermore, considerable savings could be had in the general expenses. The specialization can be done by delegating routine jobs to the subordinate staff. Therefore, the management of a large firm can concentrate on more difficult problems of production. There can also be functional specialization on the managerial side. The managerial functions can be divided and handed over to separate departments. Each department will be managed by an expert. 3. Financial economies: The economies arise when a firm grows and expands its scale of operation. A large firm can command better credit facilities at favourable rates of interest. The loans raised by large firms are self-liquidating. 4. Marketing or commercial economies: These refer to the marketing economies enjoyed by a firm when it expands its scale of production. These include economies on the purchase as well as the selling sides of a large firm. A large firm is able to secure the supply of raw materials at a favourable price. It buys large quantities and has a better bargaining position. Similarly, a large firm enjoys distinct advantages on the selling side also. It can maintain a separate sales department and employ dynamic sales staff. It can spend large amounts on advertisements. 5. Risk-bearing economies: Large scale producers spread their risk by diversification and this gives the strength of survival. Market fluctuations would not affect them in a bigger way as they can easily manipulate the stock by channelizing, storing, diversifying or keeping them blocked in differ- ent markets. They can create stocks as well as absorb stocks in the marketing field. A large firm can diversify the product or diversify the market in order to meet business risk. External Economies External economies are the benefits accruing to the industry as a whole because of its growth and the benefits are shared by all the firms of the industry. These economies are not generated by the firms individually, but arise outside due to the structure either created jointly or by the helping hand of the government. Such economies include specialized transport facilities, other commercial facilities and banking facilities created when an industry grows thick in a particular region. Even subsidiary industries started around the nucleus industry stand to benefit by the external econo- mies created by the concentration of industry in an area. A common association of all the producers M07_GENERAL_ECONOMI_7989_CH07.indd 119 8/7/2014 10:16:19 AM  A.120 l Theory of Production and Costs can effectively project external facilities by properly representing to the civic or state authorities to safeguard the interest of the different units functioning in the industrial area. External economies can be classified as: 1. Economies of information: Large firms of a particular industry can combine together and publish trade and technical journals and bulletins. They can also arrange for combined research programmes and also for useful exchange of technical information. 2. Economies of concentration: When large firms are concentrated in a particular area, it offers several benefits such as availability of skilled labour, development of means of transport, availability of credit facilities, growth of ancillary industries, and so on. 3. Economies of specialization: When an industry grows, two types of specialization are possible. (a) Horizontal specialization: If there are four steel firms, then one firm will produce raw steel, another firm will produce rods, and another will produce machinery. (b) Vertical specialization: End firm produce goods of final consumption. There are different stages involved in the production of a commodity. Each stage of production is carried out by different firms. Disadvantages of Large Scale Production The large scale production has following limitations: 1. If production is miscalculated over and above the market demand, there will be widespread glut in the market, thereby causing recessionary condition to the trade. 2. Labour trouble and unrest is the bane of large scale operation with an army of labourers. The relationship between employers and employees does not remain cordial. They very often come into clash with each other on various issues such as hours of work, wages, leave facilities, bonus, and so on. Organized strike, sabotage, and lock out would eventually lead to poor functioning of the productive mechanism in the economy. 3. Large scale production would eventually lead to monopolistic combinations into trusts, cartels, syndicate or federation. Monopolistic production may prove detrimental to the consumer and also to labour as well as t the economy in general if the organization is not conducted on sound principles of democracy, consumer interest, and labour protection. Monopoly would lead to economic concentration and finally it may go to the extent of threatening the government. 4. Large scale production is not suitable for certain lines of production of articles requiring artis- tic skills, and personal attention. For example, embroidery, silk saris, gold and silver-laced gar- ments, carpets of excellence, shawls of artistic designs, and so on can be produced only on a small scale. 5. Beyond certain stage, the enterprise becomes too cumbersome and unwieldy; consequently leakage, inefficiency and wastage may result. The task of supervision becomes difficult. Eventu- ally, it would lead to a system of checks and counter-checks leading to wastage of time, energy and money, red-tapism would be the final outcome and not production. 6. Technical obstacles such as shortage of availability of capital, raw materials, and power may arise in the way of expansion and may pose a limitation to production. 7. The economic limitation occurs in the absence of technical improvement and technologi- cal progress. A point of maximum returns would be reached in production. When this opti- mum level of production is reached, further output would result in uneconomical proposition. M07_GENERAL_ECONOMI_7989_CH07.indd 120 8/7/2014 10:16:19 AM  Theory of Production l A.121 The cost will be increasing on many counts and the profit margin would diminish. As soon as these disadvantages begin to manifest in production, it is desirable to start another factory, rather than expand the existing unit indefinitely and face diminishing returns progressively. 8. When there is large scale production, it creates environmental pollution such as air pollution, water pollution, noise pollution, and so on. M07_GENERAL_ECONOMI_7989_CH07.indd 121 8/7/2014 10:16:19 AM