Managerial Economics Unit 5

Unit 5 Production Analysis

Structure:
5.1 Introduction
Case Let
Objectives
5.2 Production and Production Function
5.3 Production Function with One Variable Input
5.4 Production Function with Two Variable Inputs
5.5 Returns to Scale
5.6 Economies of Scale
5.7 Economies of Scope
5.8 Summary
5.9 Glossary
5.10 Terminal Questions
5.11 Answers
5.12 Case Study
Reference/E-Reference

5.1 Introduction
In the previous unit, we learnt about how demand and supply interact
leading to market equilibrium. You may realise that a good can be supplied
only after it is produced. The production process involves a series of steps
to convert some raw materials and/or other inputs into a good or service. In
this unit, we will study the issues involved in the processes of production of
a good or service.
A business firm is an economic unit. It is also a production unit. Production
is one of the most important activities of a firm in the circle of economic
activity. The main objective of production is to satisfy the demand for
different kinds of goods and services of the community.

Case Let (Continued from Unit 4)

In the previous unit, we learnt that Ramesh was asked to undertake
supply analysis of traverse rods and also examine pricing of traverse
rods in the market. Ramesh undertook detailed analyses of the supply of

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traverse rods and presented the findings to his superior. The findings
broadly indicated that various firms in the market supplied traverse rods
of different kinds with the prices of the rods varying across brands and
markets. Ramesh’s report had also observed that the demand for
traverse rods was expected to grow during the next few years due to
favourable market conditions. Ramesh’s superior discussed the report
with the head of the firm. The next day, Ramesh was informed that the
firm was now planning to increase the production of traverse rods by
increasing production capacity and by introducing new varieties of
traverse rods. Ramesh was asked by his superior to examine ways of
managing the higher production by using the available resources in a
highly efficient manner within budget constraints. This was a new
challenge for Ramesh who hadn’t carried out such an assignment in the
past.

Objectives:
After studying this unit, you should be able to:
 explain the concept of production, production function and its managerial
uses
 analyse short term and long term production function with illustrations
 describe the various dimensions, advantages and demerits of large
scale production

5.2 Production and Production Function

In this section, we will discuss the concept of production and the production
function. Figure 5.1 depicts the concept of production.

Inputs
Transformation
Process Outputs

Entry into
Firms Exit of Firms

Figure 5.1: Concept of Production

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The term “production” means transformation of physical “inputs” into

physical “outputs”.
The term “inputs” or “factors of production” includes all items or those things
which are required by the firm to produce a particular product. There are
four general factors in production like land, labour, capital and organisation.
Along with those four factors there are some more factors added to the
factors of production, for example inputs also include other items like raw
materials of all kinds, power, fuel, water, technology, time and services like
transport and communications, warehousing, marketing, banking, shipping
and insurance, etc. It also includes the ability, talents, capacities,
knowledge, experience and wisdom of human beings. Thus, the term
“inputs” has wider meaning in economics. What we get at the end of
productive process is called as “outputs”. In short, “outputs” refer to finished
products.
Always, the results after production will be either creation of new utilities or
addition of values. This is an activity which increases consumer satiability of
goods and services. Production will be taken over by all producers by
incurring costs of production. Then production analysis is made in physical
terms and it shows the relationship between physical inputs and physical
outputs.
It is to be noted that higher levels of production is an index of progress and
growth of an organisation and that of a society. It leads to higher income,
employment and economic prosperity. Production of different types of goods
and services in different nations indicates the nature of economic
interdependence between different nations.
Production function
The entire theory of production centres revolves around the concept of
production function. A “production function” expresses the technological or
engineering relationship between physical quantity of inputs employed and
physical quantity of outputs obtained by a firm. It specifies a flow of output
resulting from a flow of inputs during a specified period of time. It may be in
the form of a table, a graph or an equation specifying maximum output rate
from a given amount of inputs used. As it relates inputs to outputs, it is also
called “input-output relation.” The production is purely physical in nature and

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is determined by the quantum of technology, availability of equipments,

labour, raw materials, etc. employed by a firm.
A production function can be represented in the form of a mathematical
model or equation as Q = f (L, N, K….etc) where Q stands for quantity of
output per unit of time and L, N, K etc are the various factor inputs like land,
capital, labour, etc which are used in the production of output. The rate of
output Q is thus, a function of the factor inputs L, N, K etc, employed by the
firm per unit of time.
Factor inputs are of two types as follows:
1. Fixed inputs – Fixed inputs are those factors the quantity of which
remains constant irrespective of the level of output produced by a firm,
for example, land, buildings, machines, tools, equipments, superior
types of labour, top management, etc.
2. Variable inputs – Variable inputs are those factors the quantity of which
varies with variations in the levels of output produced by a firm, for
example, raw materials, power, fuel, water, transport, communication,
etc.
The distinction between the two will hold good only in the short run. In the
long run, all factor inputs will become variable in nature.
Short run is a period of time in which only the variable factors can be varied
while fixed factors like plants, machineries, top management etc would
remain constant. Time available at the disposal of a producer to make
changes in the quantum of factor inputs is limited in the short run. Long run
is a period of time wherein the producer will have adequate time to make
changes in the factor combinations.
It is necessary to note that production function is assumed to be a
continuous function, i.e. it is assumed that a change in any of the variable
factors produces corresponding changes in the output.
Generally speaking, there are two types of production functions. They are as
follows:
1. Short run production function – In this case, the producer will keep all
fixed factors as constant and change only a few variable factor inputs. In
the short run, we come across two kinds of production functions:

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 Quantities of all inputs both fixed and variable will be kept constant
and only one variable input will be varied, for example, law of
variable proportions.
 Quantities of all factor inputs are kept constant and only two variable
factor inputs are varied, for example, iso-quants and iso-cost curves.
2. Long run production function – In this case, the producer will vary the
quantities of all factor inputs, both fixed as well as variable in the same
proportion, for example, the laws of returns to scale.
Each firm has its own production function which is determined by the state
of technology, managerial ability, organisational skills, etc of a firm. It may
be in the following manner:
1. The quantity of inputs may be reduced while the quantity of output may
remain same.
2. The quantity of inputs may be reduced while the quantity of output may
increase.
3. The quantity of inputs may be kept constant while the quantity of output
may increase.
If there are any improvements in the firm, the old production function is
disturbed and a new one takes its place.
Uses of production function
Though production function may appear as highly abstract and unrealistic, in
reality, it is both logical and useful. It is of immense utility to the managers
and executives in the decision making process at the firm level.
There are several possible combinations of inputs and, decision makers
have to choose the most appropriate among them. The following are some
of the important uses of production function:
1. It can be used to calculate or work out the least cost input combination
for a given output or the maximum output-input combination for a given
cost.
2. It is useful in working out an optimal and economic combination of inputs
for getting a certain level of output. The utility of employing a unit of
variable factor input in the production process can be better judged with
the help of production function. Additional employment of a variable
factor input is desirable only when the marginal revenue productivity of

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that variable factor input is greater than or equal to cost of employing it

in an organisation.
3. Production function also helps in making long run decisions. If returns to
scale are increasing, it is wise to employ more factor units and increase
production. If returns to scale are diminishing, it is unwise to employ
more factor inputs & increase production. Managers will be indifferent
whether to increase or decrease production, if production is subject to
constant returns to scale.
Thus, production function helps both in the short run and long run decision -
making process.

5.3 Production Function with One Variable Input

In this section, we will discuss the concept of production function with single
variable input. This concept can be elaborated through the law of variable
proportions.
The law of variable proportions
This law is one of the most fundamental laws of production. It gives us some
key insights in determination of the ideal combination of factor inputs. All
factor inputs are not available in plenty. Hence, in order to expand the
output, scarce factors must be kept constant and variable factors are to be
increased in greater quantities. Additional units of a variable factor on the
fixed factors will certainly mean a variation in output. The law of variable
proportions or the law of non-proportional output will explain how variation in
one factor input leads to variations in output.
The law can be stated as follows: “As the quantity of only one factor input is
increased to a given quantity of fixed factors, beyond a particular point, the
marginal, average and total output eventually decline”.
The law of variable proportions is the new name for the famous “law of
diminishing returns” of classical economists. This law is stated by various
economists. According to Prof. Benham, “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”.

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The same idea has been expressed by Prof. Marshall in the following words:
“An increase in the quantity of a variable factor added to fixed factors, at the
end results in a less than proportionate increase in the amount of product,
given technical conditions”.
Assumptions of the law
Some assumptions of the law of variable proportions are as follows:
 Only one variable factor unit is to be varied while all other factors should
be kept constant.
 Different units of a variable factor are homogeneous.
 Techniques of production remain constant.
 The law will hold good only for a short and a given period.
 There are possibilities for varying the proportion of factor inputs.
Let us see an illustration for better understanding.
Illustration
A hypothetical production schedule is worked out to explain the operation of
the law. Table 5.1 shows the hypothetical production schedule.
Fixed factors = 1 Acre of land + Rs 5000-00 capital. Variable factor =
labour.

Table 5.1: Hypothetical Production Schedule

Units of Variable inputs TP in AP in MP in
(Labour) units units units
0 0 0 0
1 10 10 10
I Stage
2 24 12 14
3 39 13 15
4 52 13 13
5 60 12 8
6 66 11 6 II Stage
7 70 10 4
8 72 9 2
9 72 8 0
III Stage
10 70 7 -2

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Total product or output (TP): It is the output derived from all units of
factors, both, fixed & variable, employed by the producer. It is also the sum
of marginal output.
Average product or output (AP): It can be obtained by dividing total output
by the number of variable factors employed.
Marginal product or output (MP): It is the output derived from the
employment of an additional unit of a variable factor.
Trends in output
From table 5.1, one can observe the following tendencies in the TP, AP, &
MP:
1. Total output goes on increasing as long as MP is positive. It is the
highest when MP is zero and TP declines when MP becomes negative.
2. MP increases in the beginning, reaches the highest point and diminishes
at the end.
3. AP will also have the same tendencies as the MP. In the beginning MP
will be higher than AP but at the end AP will be higher than MP.
Figure 5.2 – depicts the diagrammatic representation of the output trends.

80
E
70

60
TP

50
P
Level of Output

40 Series1
Series2
30 Series3
Stage 1 Stage 2 Stage 3
20
N
10
B AP
0
MP
1 2 3 4 5 6 7 8 9 10
-10
No. of Units of variable inputs

Figure 5.2: Diagrammatic Representation

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In figure 5.2, along the X axis, we measure the amount of variable factors
employed and, along the Y axis; we measure TP, AP & MP. From the
diagram it is clear that there are three stages.
Stage number I: Law of increasing returns
The total output increases at an increasing rate (More than proportionately)
up to the point P because corresponding to this point P the MP is rising and
reaches its highest point. After the point P, MP decline and as such TP
increases gradually. In figure 5.2, Point P does not correspond to maximum
MP. The figure has to be redrawn.
The first stage comes to an end at the point where MP curve cuts the AP
curve when the AP is maximum at N.
The stage l is called the law of increasing returns on account of the following
reasons:
1. The proportion of fixed factors is greater than the quantity of variable
factors. When the producer increases the quantity of the variable factor,
intensive and effective utilisation of fixed factors become possible
leading to higher output.
2. When the producer increases the quantity of the variable factor, output
increases due to the complete utilisation of the “indivisible factors”.
3. As more units of the variable factor are employed, the efficiency of
variable factors will go up because it creates more opportunity for the
introduction of division of labour and specialisation thereby resulting in
higher output.
Stage number II: Law of diminishing returns
In this case, as the quantity of variable inputs is increased to a given
quantity of fixed factors, output increases less than proportionately. In this
stage, the TP increases at a diminishing rate as both AP & MP are declining
but they are positive. The II stage comes to an end at the point where TP is
the highest at the point E and, MP is zero at the point B. It is known as the
stage of “diminishing returns” because both the AP & MP of the variable
factor continuously fall during this stage. It is only in this stage, the firm is
maximizing its total output.

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Diminishing returns arise due to the following reasons:

1. The proportion of variable factors is greater than the quantity of fixed
factors. Hence, both AP & MP decline.
2. Total output diminishes because there is a limit to the full utilisation of
indivisible factors and introduction of specialisation. Hence, output
declines.
3. Diseconomies of scale will operate beyond the stage of optimum
production.
4. Imperfect substitutability of factor inputs is another cause. Up to a
certain point, substitution is beneficial. Once the optimum point is
reached, the fixed factors cannot be compensated by the variable
factor. Diminishing returns are bound to appear as long as one or more
factors are fixed and cannot be substituted by the others.
Stage number III: Stage of negative returns
In this case, as the quantity of variable input is increased to a given quantity
of fixed factors, output becomes negative. During this stage, TP starts
diminishing, AP continues to diminish and MP becomes negative. The
negative returns are the result of excessive quantity of variable factors to a
constant quantity of fixed factors. Hence, output declines. Generally, the III
stage is a theoretical possibility because no producer would like to reach
this stage.
The producer, being rational, will not select either the stage I (because there
is an opportunity for him to increase output by employing more units of
variable factor) or the III stage (because the MP is negative). The
stage I & III are described as Non-Economic Region or Uneconomic Region.
Hence, the producer will select the II stage (which is described as the most
economic region) where he can maximise the output. The II stage
represents the range of rational production decision.
It is clear that in the example, the most ideal or optimum combination of
factor units = 1 Acre of land + Rs. 5000 - 00 capital and 9 labourers.
All the 3 stages together constitute the law of variable proportions. Because
the second stage is the most important, in practice we normally refer to this
law as the law of diminishing returns.

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Practical application of the law

1. It helps a producer to work out the most ideal combination of factor
inputs or the least cost combination of factor inputs.
2. It is useful to a businessman in the short run production planning at the
micro-level.
3. The law gives guidance that by making continuous improvements in
science and technology, the producer can postpone the occurrence of
diminishing returns.
Thus, we have discussed the concept of production function with single
variable input through the law of variable proportions.

5.4 Production Function with Two Variable Inputs

In this section we will discuss the concept of production function with two
variable inputs.
Isoquants and isocosts
The prime concern of a firm is to use the cheapest factor combinations to
produce a given quantity of output. There are a large number of alternative
combinations of factor inputs which can produce a given quantity of output
for a given amount of investment. Hence, a producer has to select the most
economical combination out of them. Isoproduct curve is a technique
developed in recent years to show the equilibrium of a producer with two
variable factor inputs. It is a parallel concept to the indifference curve in the
theory of consumption.
Meaning and definitions
The term “isoquant” has been derived from ‘Iso’ meaning equal and ‘Quant’
meaning quantity. Hence, isoquant is also called equal product curve or
product indifference curve or constant product curve. An isoproduct curve
represents all the possible combinations of two factor inputs which are
capable of producing the same level of output. It may be defined as – “a
curve which shows the different combinations of the two inputs producing
the same level of output”.
Each isoquant curve represents only one particular level of output. If there
are different isoquant curves, they represent different levels of output. Any
point on an isoquant curve represents the same level of output. Because

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each point indicates equal level of output, the producer becomes indifferent
with respect to any one of the input combinations.
Equal product combination
Table 5.2 shows the schedule for five factor combinations.
Table 5.2: Schedule – ‘Isoquant Schedule’
Combinations Factor X Factor Y Total Output in
(Labour) Capital units
A 12 1 100
B 8 2 100
C 5 3 100
D 3 4 100
E 2 5 100

In table 5.2, all the five factor combinations will produce an equal level of
output, i.e.100 units. Hence, the producer is indifferent with respect to any
one of the factor combinations mentioned in the table.
Graphic representation
Figure 5.3 depicts the graphical representation of factor combination.
Y

12 A

Factor 8 B
X
5 C
3 D
2
E
IQ

0 X

1 2 3 4 5
Factor Y
Figure 5.3: Graphical Representation of Factor Combination

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In figure 5.3, if we join points ABCDE (which represents different

combinations of factors x and y yielding the same level of output) we get an
isoquant curve IQ. This curve represents 100 units of output that may be
produced by employing any one of the combinations of two factor inputs as
mentioned in the example. It is to be noted that an isoproduct curve shows
the exact physical units of output that can be produced by alternative
combinations of two factor inputs. Hence, absolute measurement of output
is possible.
Isoquant map
A catalogue of different combinations of inputs with different levels of output
can be indicated in a graph which is called equal product map or isoquant
map. In other words, a number of isoquants representing different amount
of output are known as isoquant map. Figure 5.4 depicts an isoquant map.

Factor X Capital 3000 IQ3

2000
IQ2
1000
IQ1
0 Factor Y Labour X
Figure 5.4: Isoquant 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. For example, MRTS of X for Y is the number of units of
factor Y that can be replaced by one unit of factor X, quantity of output
remaining the same.

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Table 5.3 shows the MRTS of X for Y, for five different combinations.

Table 5.3: MRTS of X for Y

Combinations Factor X Factor Y MRTS of X for 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

In this example, we can notice that in the second combination the producer
is substituting 4 units of X for 1 unit of Y. Hence, in this case MRTS of
X for Y is 4:1.
Generally speaking, the MRTS will be diminishing. In the table 5.3, we can
observe that as the quantity of factor Y is increased relative to the quantity
of X, the number of units of X that will be required to be replaced by one unit
of factor Y will diminish, quantity of output remaining the same. This is
known as the law of diminishing marginal rate of technical substitution
(DMRTS).
The properties of iso-quants are as follows:
1. An isoquant curve slope downwards from left to right.
2. Generally, an isoquant curve is convex to the origin.
3. No two isoproduct curves intersect each other.
4. An isoproduct curve lying to the right represents higher output and vice-
versa.
5. Always, an isoquant curve need not be parallel to other.
6. Isoquant will not touch either X axis or Y axis.
Thus, we have learnt about MRTS, DMRTS and the isoquant.
Isocost line or curve
It is a parallel concept to the budget or price line of the consumer. It
indicates the different combinations of the two inputs which the firm can
purchase at given prices with a given outlay. It shows two things: (a) prices
of two inputs (b) total outlay of the firm. Each isocost line will show various
combinations of two factors which can be purchased with a given amount of

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money at the given price of each input. We can draw the isocost line on the
basis of an imaginary example.
Let us suppose that a producer wants to spend Rs. 3,000 to purchase factor
X and Y. If the price of X per unit Rs. 100 he can purchase 30 units of X.
Similarly if the price of factor Y is Rs. 50 then he can purchase 60 units of Y.
When 30 units of factor X are represented on OY – axis and 60 units of
factor Y are represented on OX- axis, we get two points A & B. If we join
these two points A and B, then we get the isocost line AB. This line
represents the different combinations of factor X and Y that can be
purchased with Rs. 3,000. Figure 5.5 depicts the isocost line.

A
3000/-
30 Units of Factor X

B
0 X
60 Units of Factor Y
Figure 5.5: Isocost Line

The isocost line will shift to the right if the producer increases the outlay
from Rs. 3,000 to Rs. 4,000. On the contrary, if the outlay decreases to
Rs. 2,000, there will be a backward shift in the position of isocost line.
The slope of the isocost line represents the ratio of the price of a unit of
factor X to the price of a unit of factor Y. In case, the price of any one of
them changes, there would be a corresponding change in the slope and
position of isocost line. Figure 5.6 depicts the change in the slope of the
isocost line with changes in any of the factors.

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Factor X Rs. 4,000/-

P

Rs. 3,000/-
A

Rs. 2,000/-

0 X

Factor Y

Figure 5.6: Effect of Changes in Factor on Isocost Line

Producer’s equilibrium (Optimum factor combination or least cost

combination)

The optimal combination of factor inputs may help in either minimizing cost
for a given level of output or maximizing output with a given amount of
investment expenditure (outlay). In order to explain producer’s equilibrium,
we have to integrate isoquant curve with the isocost line. isoproduct curve
represents different alternative possible combinations of two factor inputs
with the help of which, a given level of output can be produced. On the
other hand, isocost line shows the total outlay of the producer and the prices
of factors of production.

The intention of the producer is to maximise his profits. Profits can be

maximised when maximum output is produced with minimum production
cost. Hence, the producer selects the least cost combination of the factor
inputs. Maximum output with minimum cost is possible only when the
position of equilibrium is reached. The position of equilibrium is indicated at
the point where isoquant curve is tangential to the isocost line. Figure 5.7
explains how the producer reaches the position of equilibrium.

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M
E1
A

25 Units R
E Point of equilibrium
Factor “X”  E2
IQ

0 X
S B N
50 Units
Factor “Y”
Figure 5.7: Producer’s Equilibrium

It is quite clear from figure 5.7 that the producer will reach the position of
equilibrium at the point E where the isoquant curve IQ (for output of 500
units) and isocost line AB are at a tangent to each other. With a given total
outlay of Rs. 5,000 the producer will be producing the highest output,
i.e. 500 units by employing 25 units of factors X and 50 units of factor Y
(assuming Rs. 2,500 each is spent on X and Y).
The price of one unit of factor X is Rs.100 and that of Y is Rs. 50; Rs.100 x
25 units of X = 2500 and Rs. 50 x 50 units of Y = 2500. The producer will
not reach the position of equilibrium either at the point E1 and E2 because
they are on a higher isocost line. Similarly, the producer cannot move to the
left side of E, because they are on a lower isocost line and 500 units of
output cannot be produced by any combination that lies to the left of E.
Thus, the point at which the isoquant is tangent to the isocost line
represents the minimum cost or optimum factor combination for producing a
given level of output. At this point, MRTS between the two points is equal to
the ratio of the prices of the inputs.

5.5 Returns to Scale

In this section, we will discuss the long run production function.

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Laws of returns to scale

The concept of returns to scale is a long run phenomenon. In this case, we
study the change in output when all factor inputs are changed or made
available in required quantity. An increase in scale means that all factor
inputs are increased in the same proportion. In returns 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 returns to scale
Generally speaking, we study the behaviour pattern of output when all factor
inputs are increased in the same proportion under returns to scale. Many
economists have questioned the validity of returns to scale on the ground
that all factor inputs cannot be increased in the same proportion and the
proportion between the factor inputs cannot be kept uniform. But in some
cases, it is possible that all factor inputs can be changed in the same
proportion and the output is studied when the input is doubled or tripled or
increased five-fold or ten-fold. An ordinary person may think that when the
quantity of inputs is increased 10 times, output will also go up by 10 times.
But it may or may not happen as expected.
It may be noted that when the quantity of inputs are increased in the same
proportion, the scale of output or returns to scale may be either more than
equal, equal or less than equal. Thus, when the scale of output is increased,
we may get increasing returns, constant returns or diminishing returns.
When the quantity of all factor inputs are increased in a given proportion and
output increases more than proportionately, then the returns to scale are
said to be increasing; when the output increases in the same proportion,
then the returns to scale are said to be constant; when the output increases
less than proportionately, then the returns to scale are said to be
diminishing. Table 5.4 shows an example to explain the law of returns to
scale.

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Table 5.4: Laws of Returns to Scale

Sl. Total Product Marginal Product
Scale
No. in Units in units
1 1 Acre of land + 3 labour 5 5
2 2 Acre of land + 5 labour 12 7
3 3 Acre of land + 7 labour 21 9
4 4 Acre of land + 9 labour 32 11
5 5 Acre of land + 11 labour 43 11
6 6 Acre of land + 13 labour 54 11
7 7 Acre of land + 15 labour 63 9
8 8 Acre of land + 17 labour 70 7

It is clear from the table that the quantity of land and labour (scale) is
increasing in the same proportion, i.e. by 1 acre of land and 2 units of labour
throughout in our example. The output increases more than proportionately
up to the point where the producer is employing 4 acres of land and 9 units
of labour. Output increases in the same proportion when the quantity of land
is 5 acres and 11 units of labour and 6 acres of land and 13 units of labour.
In the later stages, when the producer employs 7 & 8 acres of land and
15 & 17 units of labour, output increases less than proportionately. Thus,
one can clearly understand the operation of the three phases of the laws of
returns to scale with the help of the table.
Diagrammatic representation
Figure 5.7 depicts the marginal returns curve. In the figure, it is clear that the
marginal returns curve slope upwards from A to B, indicating increasing
returns to scale. The curve is horizontal from B to C indicating constant
returns to scale and from C to D, the curve slope downwards from left to
right indicating the operation of diminishing returns to scale.

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II Stage
Y Constant returns
B C
10 

8  III Stage
Decreasing
6  I Stage returns
Increasing returns
Marginal Returns

D
4  A

2 

        X
1 2 3 4 5 6 7 8
Figure 5.8: Marginal Returns Curve

Increasing returns to scale

Increasing returns to scale is said to operate when the producer is
increasing the quantity of all factors [scale] in a given proportion leading to a
more than proportionate increase in output. For example, when the quantity
of all inputs are increased by 10%, and output increases by 15%, then we
say that increasing returns to scale is operating. In order to explain the
operation of this law, an equal product map has been drawn with the
assumption that only two factors X and Y are required. Figure 5.9 depicts
the operation of the law of increasing returns to scale. In the figure, Factor X
is represented along OX axis and factor Y is represented along OY axis.
The scale line OP is a straight line passing through the origin on the
isoquant map indicating the increase in scale as we move upward. The
scale line OP represent different quantities of inputs where the proportion
between factor X and factor Y is remains constant. When the scale is
increased from A to B, the return increases the output from 100 units to 200
units. The scale line OP passing through origin is called as the “expansion
path”. Any line passing through the origin will indicate the path of expansion
or increase in scale with definite proportion between the two factors. It is
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very clear that the increase in the quantities of factor X and Y [scale] is small
as we go up the scale and the output is larger. The distance between each
isoquant curve is progressively diminishing. It implies that in order to get an
increase in output by another 100 units, a producer is employing lesser
quantities of inputs and his production cost is declining. Thus, the law of
increasing returns to scale is operating.
Y

P
Factor ‘Y’ Capital)

Scale Line

F 600
E 500
D 400
C
300
B
200
A
100

X
0 Factor ‘X’ (Labour)

Figure 5.9: Operation of Increasing Returns of Scale

Causes for increasing returns to scale

Increasing returns to scale operate in a firm on account of several reasons.
Some of the most important ones are as follows:
1. Wider scope for the use of latest tools, equipments, machineries,
techniques etc to increase production and reduce cost per unit.
2. Large-scale production leads to full and complete utilisation of indivisible
factor inputs leading to further reduction in production cost.
3. As the size of the plant increases, more output can be obtained at lower
cost.
4. As output increases, it is possible to introduce the principle of division
of labour and specialisation, effective supervision and scientific
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management of the firm etc leading to reduction in average cost of

operations.
5. As output increases, it becomes possible to enjoy several other kinds of
economies of scale like overhead, financial, marketing and risk-bearing
economies, etc, which are responsible for cost reduction.
It is important to note that economies of scale outweigh diseconomies of
scale in case of increasing returns to scale.
Constant returns to scale
Constant returns to scale is operating when all factor inputs [scale] are
increased in a given proportion leading to an equi-proportional increase in
output. When the quantity of all inputs is increased by 10%, and output also
increases exactly by 10%, then we say that constant returns to scale are
operating. Figure 5.10 depicts a graph for constant returns to scale. In the
figure, it is clear that the successive isoquant curves are equidistant from
each other along the scale line OP. It indicates that as the producer
increases the quantity of both factors X and Y in a given proportion, output
also increases in the same proportion. Economists also describe constant
returns to scale as the linear homogeneous production function. It shows
that with constant returns to scale, there will be one input proportion which
does not change, whatever be the level of output.

P
Scale Line
Factor ‘Y’ (Capital)

E
D 500 units
C 400 units
B 300 units
A 200 units
100 units

0 X
Factor ‘X’ (Labour)

Figure 5.10: Constant Returns to Scale

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Causes for constant returns to scale

In case of constant returns to scale, the various internal and external
economies of scale are neutralized by internal and external diseconomies.
Thus, when both internal and external economies and diseconomies are
exactly balanced with each other, constant returns to scale will operate.
Diminishing returns to scale
Diminishing returns to scale is operating when output increases less than
proportionately when compared to the quantity of inputs used in the
production process. For example, when the quantity of all inputs are
increased by 10%, and output increases by 5%, then we say that
diminishing returns to scale is operating.
Figure 5.11 depicts the diminishing return to scales. In the figure, it is clear
that the distance between each successive isoquant curve is progressively
increasing along the scale line OP. It indicates that as the producer is
increasing the quantity of both factors X and Y, in a given proportion, output
increases less than proportionately. Thus, the law of diminishing returns to
scale is operating.

Y
P
Scale Line

F
Factor ‘Y’ (Capital)

E 600 units
D
500 units
C
B 400 units
A 300 units
200 units
100 units
0 X
Factor ‘X’ (Labour)

Figure 5.11: Diminishing Returns to Scale

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Causes for diminishing returns to scale

Diminishing Returns to Scale operate due to the following reasons:
1. Emergence of difficulties in co-ordination and control.
2. Difficulty in effective and better supervision.
3. Delays in management decisions.
4. Inefficient and mismanagement due to overgrowth and expansion of the
firm.
5. Productivity and efficiency declining unavoidably after a point.
Thus, in this case, diseconomies outweigh economies of scale. The result is
the operation of diminishing returns to scale.
The concept of returns to scale helps a producer to work out the most
desirable combination of factor inputs so as to maximise output and
minimise production cost. It also helps the producer to increase production,
maintain the same level or, decrease it depending on the demand for the
product.

5.6 Economies of Scale

In this section, we will study the economies of scale. The study of
economies of scale is associated with large scale production. Today there is
a general tendency to organize production on a large scale. Mass
production of standardized goods has become the order of the day. Large
scale production is beneficial and economical in nature. The advantages or
benefits that accrue to a firm as a result of increase in its scale of production
are called ‘economies of scale’. They have close relationship with the size of
the firm. They influence the average cost over different ranges of output.
They are beneficial to a firm. They help in reducing production cost and
establishing an optimum size of a firm. Thus, they help a lot and, go a long
way in the development and growth of a firm. According to Prof. Marshall,
such economies are of two types, viz., internal economies and external
economies. Now we shall study both of them in detail.
I. Internal economies or real economies
Internal economies are those economies which arise because of the actions
of an individual firm to economise its cost. They arise due to increased
division of labour or specialisation and complete utilisation of indivisible

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factor inputs. Prof. Cairncross points out that the internal economies are
open to a single factory or a single firm, independent of the actions of other
firms. Some of the important aspects of internal economies are as follows:
1. They arise “within” or “inside” a firm.
2. They arise due to improvements in internal factors.
3. They arise due to specific efforts of one firm.
4. They are particular to a firm and enjoyed by only one firm.
5. They arise due to increase in the scale of production.
6. They are dependent on the size of the firm.
7. They can be effectively controlled by the management of a firm.
8. They are called as “business secrets” of a firm.
Internal economies arise on account of an increase in the scale of output of
a firm and cannot be achieved unless output increases.
Kinds of internal economies
Now, let us discuss the kinds of internal economies.
Technical economies
These economies arise on account of technological improvements and their
practical application in the field of business. Economies of techniques or
technical economies are further subdivided into five heads as follows:
a) Economies of superior techniques – These economies are the result of
the application of the most modern techniques of production. When the size
of the firm grows, it becomes possible to employ bigger and better types of
machinery. The latest and improved techniques give place for specialized
production. It is bound to be cost reducing in nature, for example, cultivating
the land with modern tractors instead of using age old wooden ploughs and
bullock carts, use of computers instead of human labour, etc.
b) Economies of increased dimension – It is found that a firm enjoys the
reduction in cost when it increases its dimension. A large firm avoids
wastage of time and economizes its expenditure. Thus, an increase in
dimension of a firm will reduce the cost of production, for example, operation
of a double-decker bus instead of two separate buses.

c) Economies of linked processes – It is quite possible that a firm may not

have various processes of production within its own premises. Also, it is
possible that different firms through mutual agreement may decide to work

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together and derive the benefits of linked processes, for example, in dairy
farming, printing press, nursing homes, etc.

d) Economies arising out of research and by-products – A firm can

invest adequate funds for research and, the benefits of research and its
costs can be shared by that firm as well as all other firms in the industry.
Similarly, a large firm can make use of its wastes and by-products in the
most economical manner by producing other products. For example, cane
pulp, molasses, and bagasse of sugar factory can be used for the
production of paper, varnish, etc.
e) Inventory economies – Inventory management is a part of better
materials management. A big firm can save a lot of money by adopting
latest inventory management techniques. For example, Just-In-Time or zero
level inventory techniques. The rationale of the Just-In-Time technique is
that instead of having huge stocks worth of lakhs and crores of rupees, it
can ask the seller of the inputs to supply them just before the
commencement of work in the production department each day.
Managerial Economies
They arise because of better, efficient, and scientific management of a firm.
Such economies arise in two different ways as follows:
a) Delegation of details – The general manager of a firm cannot look after
the working of all processes of production. In order to keep an eye on each
production process he has to delegate some of his powers or functions to
trained or specialized personnel and thus relieve himself for co-ordination,
planning and executing the plans. This will enable him to bring about
improvements in production process and in bringing down the cost of
production.
b) Functional specialisation – It is possible to secure economies of large
scale production by dividing the work of management into several separate
departments. Each department is placed under an expert and the rest of the
work is left into the hands of specialists. This will ensure better and more
efficient productive management with scientific business administration. This
would lead to higher efficiency and reduction in the cost of production.
Thus managerial economies are mainly governed by proper delegation of
details and by functional specialisation.

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Marketing or commercial economies

These economies arise on account of buying and selling goods on large
scale basis at favourable terms. A large firm can buy raw materials and
other inputs in bulk at concessional rates. As the bargaining capacity of a
big firm is much greater than that of small firms, it can get quantity discounts
and rebates. In this way, economies may be secured in the purchase of
different inputs.
A firm can reduce its selling costs also. A large firm can have its sales
agency and channel. The firm can have a separate selling organisation,
marketing department manned by experts who are well-versed in the art of
pushing the products in the market. It can follow an aggressive sales
promotion policy to influence the decisions of the consumers.
Financial economies
They arise from advantages secured by a firm in mobilizing huge financial
resources. A large firm on account of its reputation, name and fame can
mobilize huge funds from money market, capital market, and other private
financial institutions at concessional interest rates. It can borrow from banks
at relatively cheaper rates. It is also possible to have large overdrafts from
banks. A large firm can float debentures and issue shares and get
subscriptions from the general public. Another advantage will be that the
raw material suppliers, machine suppliers etc., are willing to supply
materials and components at comparatively low prices, because they are
likely to get bulk orders. Thus, a big firm has an edge over small firms in
securing sufficient funds more easily and cheaply.
Labour economies
These economies arise as a result of employing skilled, trained, qualified
and highly experienced persons by offering higher wages and salaries. As a
firm expands, it can employ a large number of highly talented persons and
get the benefits of specialisation and division of labour. It can also impart
training to existing labour force in order to raise skills, efficiency and
productivity of workers. New schemes may be chalked out to speed up the
work, conserve scarce resources, economise on expenditure and save
labour time. It can provide better working conditions, promotional
opportunities, restrooms, sports rooms etc, and create facilities like
subsidised canteen, crèches for infants, recreations. All these measures will

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definitely raise the average productivity of a worker and reduce the cost per
unit of output.
Transport and storage economies
They arise on account of the provision of better, highly organised and cheap
transport and storage facilities and their complete utilisation. A large
company can have its own fleet of vehicles or means of transport which are
more economical than hired ones. Similarly, a firm can also have its own
storage facilities which reduce cost of operations.
Overhead economies
These economies arise on account of large scale operations. The expenses
on establishment, administration, book-keeping, etc, are more or less the
same whether production is carried out on a small or large scale. Hence,
cost per unit will be low if production is organised on a large scale.
Economies of vertical integration
A firm can also reap this benefit when it succeeds in integrating a number of
stages of production. It secures the advantage that the flow of goods
through various stages in production processes is more readily controlled.
Because of vertical integration, most of the costs become controllable costs
which help an enterprise to reduce cost of production.
Risk-bearing or survival economies
These economies arise as a result of avoiding or minimising several kinds of
risks and uncertainties in a business. A manufacturing unit has to face a
number of risks in the business. Unless these risks are effectively tackled,
the survival of the firm may become difficult. Hence, many steps are taken
by a firm to eliminate or to avoid or to minimise various kinds of risks. A
large firm secures risk-spreading advantages in either of the following four
ways or through all of them:
 Diversification of output – Instead of producing only one particular
product, a firm has to produce multiple products. If there is loss in one
product, it can be made good in other products.
 Diversification of market – Instead of selling the goods in only one
market, a firm has to sell its products in different markets. If consumers
in one market desert a product, it can cover the losses in other markets.
 Diversification of source of supply – Instead of buying raw materials
and other inputs from only one source, it is better to purchase them from
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different sources. If one person fails to supply, a firm can buy from
several sources.
 Diversification of the process of manufacture – Instead of adopting
only one process of production to manufacture a commodity, it is better
to use different processes or methods to produce the same commodity
so as to avoid the loss arising out of the failure of any one process.
Generally speaking, the risk-bearing capacity of a big firm will be much
greater than that of a small firm. Risk is avoided when few firms
amalgamate or join together or when competition between different firms is
either eliminated or reduced to the minimum by expanding the size of the
firm.
II. External economies or pecuniary economies
External economies are those economies which accrue to the firms as a
result of the expansion in the output of the whole industry and they are not
dependent on the output level of individual firms. These economies or gains
will arise on account of the overall growth of an industry or a region or a
particular area. They arise due to benefit of localisation and specialised
progress in the industry or region. Some of the important aspects of external
economies are as follows:
1. They arise ‘outside’ the firm.
2. They arise due to improvement in external factors.
3. They arise due to collective efforts of an industry.
4. They are general, common and enjoyed by all firms.
5. They arise due to overall development, expansion and growth of an
industry or a region.
6. They are dependent on the size of industry.
7. They are beyond the control of management of a firm.
8. They are called as “open secrets” of a firm.
Stonier & Hague point out that external economies are those economies in
production which depend on increase in the output of the whole industry
rather than increase in the output of the individual firm.
Kinds of external economies
Now, let us discuss the kinds of external economies.

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Economies of concentration or agglomeration

They arise due to a very large number of firms which produce the same
commodity being established in a particular area. In other words, this is an
advantage which arises from what is called ‘Localisation of Industry’. The
following benefits of localisation of industry are enjoyed by all the firms -
provision of better and cheap labour at low or reasonable rates, trained,
educated and skilled labour, transport and communication, water, power,
raw materials, financial assistance through private and public institutions at
low interest rates, marketing facilities, benefits of common repairs,
maintenance and service shops, services of specialists or outside experts,
better use of by-products and other such benefits. Thus, it helps in reducing
the cost of operation of a firm.
Economies of information
These economies arise as a result of getting quick, latest and up-to-date
information from various sources. Another form of benefit that arises due to
localisation of industry is economies of information. As a large number of
firms are located in a region, it becomes possible for them to exchange their
views frequently, to have discussions with others, to organise lectures,
symposiums, seminars, workshops, training camps, demonstrations on
topics of mutual interest, etc. Revolution in the field of information
technology, expansion in inter-net facilities, mobile phones, e-mails,
video conferences, etc, has helped in the free flow of latest information from
all parts of the globe in a very short span of time. Similarly, publication of
journals, magazines, information papers, etc. have helped in the
dissemination of quick information. Statistical, technical and other market
information becomes more readily available to all firms. This will help in
developing contacts between different firms. When inter-firm relationship
strengthens, it helps in economising the expenditure of a single firm.
Economies of disintegration
These economies arise as a result of dividing one big unit into different
small units for the sake of convenience of management and administration.
When an industry grows beyond a limit, in that case, it becomes necessary
to split it in to small units. New subsidiary units may grow to serve the needs
of the main industry. For example, in cotton textiles industry, some firms
may specialise in manufacturing threads, a few others in printing, and some

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others in dyeing and colouring, etc. This will certainly enhance the efficiency
in the working of a firm and cut down unit costs considerably.
Economies of government action
These economies arise as a result of active support and assistance given by
the government to stimulate production in the private sector units. In recent
years, the government in order to encourage the development of private
industries has come up with several kinds of assistance. It is granting tax-
concessions, tax-holidays, tax-exemptions, subsidies, development rebates,
financial assistance at low interest rates, etc.
It is quite clear from this detailed description that both internal and external
economies arise on account of large scale production and they are benefit
to firms by reducing costs.
Economies of physical factors
These economies arise due to the availability of favourable physical factors
and environment. As the size of an industry expands, positive physical
environment may help to reduce the costs of all firms working in the
industry. For example, climate, weather conditions, fertility of the soil,
physical environment in a particular place may help all firms to enjoy certain
physical benefits.
Economies of welfare
These economies arise on account of various welfare programmes
undertaken by an industry to help its own staff. A big industry is in a better
position to provide welfare facilities to the workers. It may get land at
concessional rates and procure special facilities from the local governments
for setting up housing colonies for the workers. It may also establish health
care units, training centres, computer centres and educational institutions of
all types. It may grant concessions to its workers. All these measures would
help in raising the overall efficiency and productivity of workers.
Diseconomies of scale
When a firm expands beyond the optimum limit, economies of scale will be
converted into diseconomies of scale. Some of the main diseconomies of
scale are as follows:

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1. Financial diseconomies – As there is overgrowth, the required amount

of finance may not be available to a firm. Consequently, higher interest
rates are to be paid for additional funds.
2. Managerial diseconomies – Excess growth leads to loss of effective
supervision, control, management, coordination of factors of production
leading to all kinds of wastages, indiscipline and rise in production and
operating costs.
3. Marketing diseconomies – Unplanned excess production may lead to
mismatch between demand and supply of goods leading to fall in prices.
Stocks may pile up; sales may decline leading to fall in revenue and
profits.
4. Technical diseconomies – When output is carried beyond the plant
capacity, per unit cost will certainly go up. There is a limit for division of
labour and specialisation. Beyond a point, they become negative.
Hence, operation costs would go up.
5. Diseconomies of risk and uncertainty bearing – If output expands
beyond a limit, investment increases. The level of inventory goes up.
Sales do not go up correspondingly. Business risks appear in all fields
of activities. Supply of factor inputs become inelastic leading to high
prices.
6. Labour diseconomies – An unwieldy firm may become impersonal.
Contact between labour and management may disappear. Workers
may demand higher wages and salaries, bonus and other such benefits,
etc. Industrial disputes may arise. Labour unions may not cooperate
with the management. All of them may contribute to higher operation
costs.
On account of diseconomies of scale, more output is obtained at higher cost
of production.
II. External diseconomies
When several business units are concentrated in one place or locality, it
may lead to congestion,, environmental pollution, scarcity of factor inputs
like, raw materials, water, power, fuel, transport and communications etc
leading to higher production and operational costs.
Thus, it is very clear that a firm can enjoy benefits of large scale production
only up to a limit. Beyond the optimum limit, it is bound to experience
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diseconomies of scale. Hence, there should be proper check on the growth

and expansion of a firm.
Internalisation of external economies
It implies that a firm will convert certain external benefits created by the
government or the entire society to its own favour without making any
additional investments. A firm may start a new unit between two big railway
stations or near the airport or near the national highways or a port so that it
can enjoy all the infrastructure benefits. Similarly, a new computer firm can
commence its operations where there is 24 hours supply of electricity.
Hence, they are also called as privatisation of public benefits. Such types of
efforts are to be encouraged by the government.
Externalisation of internal diseconomies
In this case, a particular firm on account of its regular operations will pass
on certain costs on the entire society. A firm instead of taking certain
precautionary measures by spending some amount of money will escape
and pass on this burden to the government or the society. For example, a
firm may throw chemical or industrial wastes, dirt and filth either to open air
or rivers leading to environmental pollution. In that case, the government is
forced to spend more money to clean river water or prevent environmental
pollution. This is a clear case of externalised internal diseconomies. It is to
be avoided at all costs.

5.7 Economies of Scope

In this section, we will discuss the economies of scope. It is a common fact
to observe that when a single-product firm expands its volume of output, it
would enjoy certain economies of scale. As a result, production cost per unit
declines and more output is obtained at lower cost of production.
Sometimes, they would enjoy certain other external benefits due to the
overall improvements in the entire area or city in they operate. Apart from
these two types of benefits, we also come across another type of benefit in
recent years. They are popularly known as economies of scope.

Economies 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. In this case, the benefits of
the joint output of a single firm are greater than the benefits if two products
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are produced separately by two different firms. Such benefits may arise on
account of joint use of production facilities, joint marketing efforts, or use of
the same administrative office and staff in an organisation. Sometimes,
production of one product automatically results in the production of another
by-product leading to a reduction in average cost of production.

Economies-of-scope results in saving production costs. It can be measured

with the help of the following equation.

C [Q1]  C [ Q2] - C [ Q1,Q2]

SC 
C [Q1, Q2]

Where SC = Saving Cost, C [Q1] = cost of producing output Q1, C [Q2] =

cost of producing output Q2 and C [Q1, Q2] = joint cost of producing both
outputs.

Illustration
A firm produces product A & B separately. Cost of producing 100 units of A
is Rs. 8000 and cost of producing 100 units of B is Rs. 5,000. If the firm
produces both products A & B jointly, in that case, its total cost would be
Rs. 10,000.

Now, one can find out saving cost by substituting the values to the above
mentioned formula.

8,000  5,000 - 10,000 3,000

SC    0 .3
10,000 10 ,000

In this case, the joint cost [10,000] is less than the sum of individual costs
[13,000]. Thus, a firm can save 30% cost if it produces both products A & B
jointly. Hence, the SC is more than zero.

Diseconomies of scope
Diseconomies of scope may be defined as those disadvantages which occur
when the cost of producing two products jointly is costlier than producing
them individually. In this case, it would be profitable to produce two goods
separately than jointly. For example, with the help of same machinery, it is
not possible to produce two goods together. It involves buying two different
machineries. Hence, production costs would certainly go up in this case.

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Difference between economies of scale and economies of scope

Table 5.5 shows the difference or the comparison between economies of
scale and economies of scope.

Table 5.5: Comparison of Two Economies

Economies of scale Economies of scope
1. It is connected with increase or 1. It is connected with increase or
decrease in scale of production decrease in distribution & marketing.
2. It shows change in output of a 2. It shows a change in output of more
single product than one product.
3. It is associated with supply side 3. It is associated with demand side
changes in output. changes in output
4. It indicates savings in cost 4. It indicates savings in cost due to
owing to increase in volume of production of more than one product.
output

5.8 Summary
Let us recapitulate the important concepts discussed in this unit:
 In this unit, we have discussed about the meaning of production,
production function and its managerial uses. Production in economics
implies transformation of inputs into outputs for our final consumption.
 Production function explains the quantitative relationship between the
amounts of inputs used to get a particular physical quantity of outputs.
The ratios between the two quantities are of great importance to a
producer to take his decisions in the production process.
 There are two kinds of production functions - short run and long run. In
case of short run production function we come across a change in either
one or two variable factor inputs while all other inputs are kept constant.
 The law of variable proportion explain how there will be variations in the
quantity of output when there is change in only one variable factor input
while all other inputs are kept constant. On the other hand, iso-quants
and iso-cost curves explain how there will be changes in output when
only two variable inputs are changed while all other inputs are kept

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constant. Under long run production function, the laws of returns to scale
explain changes in output when all inputs, both variable as well as fixed
changes in the same proportion.
 Economies of scale gives information about the various benefits that a
firm will get when it goes for large scale production. Economies of scope
on the other hand tells us how there will be certain specific advantages
when one firm produces more than two products jointly than two or three
firms produce them separately. Diseconomies of scale and
diseconomies of scope tell us that there are certain limitations to
expansion in output.

5.9 Glossary
Economies of scale: Advantages or benefits that accrue to a firm as a
result of increase in its scale of production.
Economies of scope: 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.
Isocost line: Indicates the different combinations of the two inputs which
the firm can purchase at given prices with a given outlay.
Isoquant/isoproduct curve: A curve which shows the different
combinations of the two inputs producing the same level of output.
Law of variable proportions: As the quantity of only one factor input is
increased to a given quantity of fixed factors, beyond a particular point, the
marginal, average and total output eventually decline.
Long run: Period of time wherein the producer will have adequate time to
make changes in the factor combinations.
Marginal rate of technical substitution: Rate at which a factor of
production can be substituted for another at the margin without affecting any
change in the quantity of output.
Production: Transformation of physical Inputs into physical outputs.
Production function: Technological or engineering relationship between
physical quantity of inputs employed and physical quantity of outputs
obtained by a firm.
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Short run: Period of time in which only the variable factors can be varied
while fixed factors like plants, machineries, top management, etc. would
remain constant.

Self Assessment Questions

1. Production creates ___________ or ___________ of value.
2. Production function explains _____________ or ________________
relationship between inputs and outputs.
3. In the short period only ___________ factor inputs are changed.
4. When marginal product is zero total product will be _________.
5. An iso-quant curve shows different alternative combinations of inputs
which helps to produce same level of output where as an iso-cost curve
shows ____________ combination of two inputs that can be purchased
with a given amount of investment expenditure while prices of two
factor inputs remain constant.
6. When all inputs are increased by 8% and output increases by 13% then
it is a case of law of ____________________.
7. Internal economies depend on the growth of a ___________ and
external economies depend on the growth of the ____________.
8. Economies of scope refer to the benefits which arise to a firm when it
produces more than _________________ rather than producing
________ separately by two firms.
9. A short-run production function assumes that the level of output is
fixed. (True/False)
10. When average product is increasing, then marginal product is greater
than average product. (True/False)
11. All inputs are fixed in the short run. (True/False)
12. If a firm is producing a given level of output in a technically efficient
manner, that level of output is the most that can be produced with the
given levels of inputs. (True/False)
13. Diminishing returns refer to the decrease in marginal product, which
results from increases in the variable input. (True/False)

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5.10 Terminal Questions

1. Define production function and distinguish between short run and long
run production function.
2. Discuss the uses of production function.
3. Explain the law of variable proportions.
4. Explain how a product would reach equilibrium position with the help
of –iso-quants and iso-cost curve.
5. Discuss any one law of returns to scale with example.

5.11 Answers

Self Assessment Questions

1. New utilities, addition
2. Technological, engineering
3. Variable
4. Highest
5. Various alternative, particular
6. Diminishing returns
7. Firms industry
8. One product jointly
9. False
10. True
11. False
12. True
13. True
Terminal Questions
1. The entire theory of production centres revolves around the concept of
production function. In short run Quantities of all inputs both fixed and
variable will be kept constant and only one variable input will be varied,
for example, law of variable proportions. In long run the producer will
vary the quantities of all factor inputs, both fixed as well as variable in
the same proportion Refer to section 5.2.
2. It is of immense utility to the managers and executives in the decision-
making process at the firm level Refer to section 5.2.

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3. Law of variable proportions gives a key insights in determination of the

ideal combination of factor inputs. All factor inputs are not available in
plenty Refer to section 5.3.
4. Isoquant is also called equal product curve or product indifference curve
or constant product curve. Isoquant curve represents only one particular
level of output. Refer to section 5.4.
5. The change in output when all factor inputs are changed or made
available in required quantity. Refer to section 5.5.

5.12 Case Study

Hua Hong, Grace Semiconductor to Merge

HONG KONG – Hua Hong Semiconductor Ltd. and Grace
Semiconductor Manufacturing Corp. agreed to merge, the companies
said Thursday, in a move that highlights consolidation in China's
fragmented semiconductor industry. The tie-up, which includes Hua
Hong's issuing new shares to existing shareholders of Grace in exchange
for all of Grace's outstanding shares, will create a stronger competitor to
China's largest chip foundry; Semiconductor Manufacturing International
Corp. SMIC has been struggling to compete against its Taiwan rivals.
It also shows the capital-intensive contract-chip-manufacturing industry is
forcing companies to look at ways to partner up and save costs on
investments to keep advanced production lines running. "By integrating
manufacturing facilities, process technologies and human resources, Hua
Hong and Grace are able to leverage their complementary strengths to
further expand their combined product range and customer coverage and
to improve economies of scale", said Fu Wenbiao, chairman of the
merged company.
For many years, China has looked to foster its semiconductor industry to
make it more competitive against rivals in Japan, Taiwan and Korea. Until
now, the only main competitor to companies like Taiwan Semiconductor
Manufacturing Co. and United Microelectronics Corp. – the world's two
biggest contract-chip manufacturers by revenue – was SMIC. But over
the past few years, SMIC has failed to upgrade its production technology,
putting the company in the red.

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In a bid to boost its chip industry, China has also given tax breaks to
foreign companies that are looking to set up advanced manufacturing
facilities in the mainland to take advantage of lower manufacturing costs.
Discussion Questions:
1. How can mergers and acquisitions help companies to achieve
economies of scale?
2. While the above example relates to the semiconductor industry, how
could business firms achieve economies of scale in sectors such as
the food processing sector and the voice-based business process
outsourcing sector?
(Source: The Wall Street Journal, 30th December 2011)
Hint: With the help of the theoretical concepts build your views in this
case study.

References:
 Benham F., (1960), Economics: A general introduction, Sir Isaac Pitman
& Sons.
 Marshall, Alfred (1920), Principles of Economics, 8th edition, Macmillan &
Co.
 Stonier Alfred William, & Hague Douglas Chalmers., (1980), A textbook
of economic theory, Edition 5, Longman.

E-Reference:
 www.economictimes.com – retrieved on 30th December 2011

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