PRODUCTION ANALYSIS

Concept
Production analysis or theory of production deals with a relationship between
input factors and output of goods or services. The production analysis
concentrates only upon the operational efficiency for optimum output while the
cost of production is not considered. But the cost of production is an important
factor for any businessman or a decision maker.

Similarly, economic conditions and revenues are also related with each other.

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Equilibrium between demand and supply is required to be maintained and
cannot be ignored as in pure production analysis.

Hence, it is required to be clearly understood that the decisions on production

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cannot be made only on physical production and operating efficiency.

Concept of Production
Economics refers the production as an activity performed in a planned manner
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by man with the utilisation or conversion of natural resources. The production
can also be termed as an economic activity which converts inputs into outputs
or services with addition of utility.
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Utility is defined as the capacity of products and services that satisfy the
requirements of the people. The processes of production create utility to
products or services by providing 'form utility', 'place utility' and 'time utility'.

According to James Bates and J.R. Parkinson, "Production is the

organised activity of transforming resources into finished products in the form
of goods and services; and the objective of production is to satisfy the demand
of such transformed resources".

According to J.R. Hicks, "Production in any activity directed to the

satisfaction of other people's want through exchange".

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Factors of Production
A number of resources are required for any kind of production process.
Factors of production are nothing but the resources used in production
processes to develop an output or a product. In order to make it convenient,
all the resources are grouped into four main categories, i.e., land, labour,
capital, and entrepreneur. These are described below:

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Land: In economics, the term 'land' is used differently. It is not simply a piece
of Earth's surface or soil but includes other elements of the nature which
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covers vegetation, soil fertility, air, water, etc.
According to Marshall, "Land means the material and the forces which
nature gives freely for man's aid, in land and water, in air, light and heat".

Labour: In any production process, the amount of physical or mental efforts

committed towards the production of different goods and services is called
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'labour'. Use of skills or intellect by an individual is also a labour. In economic
terms, any kind of activity done by an individual to gain economic reward is
labour.
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Capital: Portion of wealth of an individual or community used in different

production processes, so as to generate more wealth is called 'capital'. It is
also called 'produced means of production' Because it is produced by man
through utilising of natural resources. Man-made instrument of production is
another definition of capital.

Entrepreneur: Entrepreneur is a factor of production, who takes risks to

initiate production process by utilising the other factors of production (i.e.,
land, labour and capital) efficiently.

The right proportion of different factors of production is prepared by the

entrepreneur. The other names to denote an entrepreneur are 'manager',
'organiser' or 'risk taker'. Entrepreneurs are involved in initiating new
production processes by taking risks.

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Production Function
Production function of a firm is a functional relationship between inputs used
and output produced by the firm.

It expresses the maximum quantity of output that can be produced with any
given quantities of input.

The given technology determines the maximum levels of output that can be
produced using different combinations of inputs.

Symbolically O x = f (i1 , i2 , i3 …………in)

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Where,
O= output of commodity x.
f= Functional relationship
i1 , i2 , i3 , ………in = inputs needed for Ox
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Example of Production function

● Suppose a firm is manufacturing chairs with the help of two inputs, say
labour (L) and capita (K). Then, production function can be written as:
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Ochairs = f(L, K)
● Production function defines the maximum chairs (Ochairs), which can be
produced with the given capital and labour inputs.
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● If production function is expressed as: 250 (7L, 2K). It means, 7 units

labour and 2 units of capital can produce maximum of 250 chairs.

More about Production Function:

1. The production function specifies either the maximum output that can be
produced with the given inputs or the maximum quantity of inputs needed to
produce a given level of output.

2. Production function establishes a relation between the inputs and output,

which is technical in nature.
Production function is not economical in nature as we do not consider the
value of inputs and output.

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3. Production function is always defined with respect to a given technology. If
there is an improvement in the technique of production, then increased output
can be obtained with the same physical inputs.

4. The production function includes only the technically efficient methods of

production as no rational entrepreneur will use inefficient methods.

Assumptions of Production Function

1) The input and output can be perfectly divided.
2) It is not necessary that one factor is substituted for the other.

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3) The state of technology does not change.
4) In short-run, the supply of fixed factors is inelastic.
5) Production function is associated with a given period of time.
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Types of Production Function
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Short-Run Production Function

A short-run production function is a single variable function. The single
variable is labour while the other variable capital is constant. It is expressed
as:
Q = f(L,K̅)
Where,
Q = Quantity of Production or Output
L = Labour
K̅ = Constant Capital

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1) Linear Function: Linear production function can be expressed as
mentioned below:
Y = a + bX
Where,
Y= Dependent Variable Representing Total Output or Total Production,
X= Independent Variable Representing Total Input (Labour), and
a and b = Constraints whose values are determined by Statistical
Analysis of Data.

It is concluded from the above function that the average product can be
written in the form of the following equation:
𝑌 𝑎
= 𝑋 +b

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𝑋

The marginal product can be written in the following form of equation as:
∆𝑌
=b
∆𝑋
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2) Quadratic Production Function: Quadratic production function
can be expressed as follows:
Y = a + bX - cX2
Where,
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Y= Dependent Variable Representing Total Output or Total Production,
X= Independent Variable Representing Total Input (Labour),and
a, b and c = Constraints whose values are determined by Statistical
Analysis of Data.
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The properties of quadratic production function are as

follows:

➔ In later stage, the minus sign represents the diminishing marginal

return.

➔ This equation is only allowed for decreasing marginal product.

➔ At every point, the elasticity of production decrease with the magnitude

of input.

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3) Cubic Production Function: Cubic production function can be
mathematically expressed as:
Y = a + bX + cX2- dX3
Where,
Y= Dependent Variable Representing Total Output or Total Production
X= Independent Variable Representing Total Input (Labour), and
a, b, c and d= Constraints whose values are determined by Statistical
Analysis of Data.

The cubic production function has essential properties which

are as follows:

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● The rise and fall of marginal productivity are allowed.
● At every point, the elasticity of production changes along the curve.
● In the later stages, the marginal productivity reduces at a faster rate.
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4) Power Function: A power function expresses output 'Y' as a function
of input 'X' (labour) in the form:
Y=a~Xβ
Where,
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Y= Dependent Variable Representing Total Output or Total Production
x= Independent Variable Representing Total Input (Labour)
a= Constraint whose value is determined by Statistical Analysis of Data
β = Elasticity of X (Labour)
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Long- Run Production Function
In long run production function both capital (K) and labour (L) are treated as
variable factors. It is expressed as:
Q = f (L, K)
Where,
Q= Quantity of Production or Output
L= Labour
K = Capital

Long-Run production functions are classified as follows:

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1) Cobb-Douglas Production Function:

Cobb-Douglas production function was developed by Charles W. Cobb and

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Paul H. Douglas who analyses the relationship between inputs and outputs.
The C-D production function was initially applicable in the entire
manufacturing production rather than the production of individual firms.

The Cobb-Douglas production function can take the following form:

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Q = ALα Kβ
Where,
Q = Output
L and K= Inputs of Labour and Capital, respectively
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A= Positive Parameters, where α＞0, β＞0

α = Output Elasticity of Labour
β = Output Elasticity of Capital

The above mentioned equation expresses that the output is directly based on
the labour (L) and capital (K) and A which is the 'residual' includes the output
which is not described by Land K and is normally known as 'technical change'.
The marginal products of labour and capital are the functions of the
parameters A, a and ẞ and the ratios of labour and capital inputs, i.e.

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In C-D production function, the degree of homogeneity is measured by two
constraints, i.e., a and ẞ which are taken simultaneously.
This function describes the returns to scale as:
α + β > 1: Increasing Returns to Scale
α + β = 1: Constant Returns to Scale
α + β < 1: Decreasing Returns to Scale

Properties of Cobb-Douglas Production Function

1) There are constant returns to scale.

2) Elasticity of substitution is equal to one.

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3) a and ẞ represent the labour and capital shares of output, respectively.
4) a and ẞ are also elasticities of output with respect to labour and capital,
respectively.
5) If one of the inputs is zero, output will also be zero.
6)
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The expansion path generated by C-D function is linear and it passes
through the origin.
7) The marginal product of labour is equal to the increase in output when
the labour input is increased by one unit.
8) The average product of labour is equal to the ratio between output and
labour input.
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9) The ratio α/β measures factor intensity. The higher is this ratio, the more
labour intensive is the technique and the lower is this ratio and the more
capital intensive is the technique of production.
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Importance of Cobb-Douglas Production Function

1) Cobb-Douglas function is convenient for international and inter-industry

comparisons. Since a and ẞ (which are partial elasticity coefficients) are pure
numbers, (i.e., independent of units of measurement) they can be easily used
for comparing the results of different samples having varied units of
measurement.

2) Another advantage is that this function captures the essential non-linearities

of production process and also has the benefit of simplification of calculations
by transforming the function into a linear form with the help of logarithms. The
log-linear function becomes linear in its parameters, which is quite useful to a
managerial economist for his analysis.

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3) In addition to being elasticities, the parameters of Cobb- Douglas function
also possess other attributes.
For example, the sum of (a + ẞ) shows the returns to scale in the production
process; a and ẞ represent the labour share and capital share of output
respectively, and so on.

4) The nature of long-run production function is examined through this

production function namely the increasing, constant and decreasing returns to
scale.

5) Although in its original form, Cobb-Douglas production function limits itself

to handling just two inputs (e.g., L and K), it can be easily generalised for

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more than two inputs, like
𝑎 𝑏 𝑐 𝑃
Q = AX 1 · X 2 · X · 3
· ………….X 𝑛
Where,
Q = Output
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X1, X2,... Xn = Different Inputs

Criticisms of Cobb-Douglas Production Function

i) Variable elasticity substitution production function neglects the employment

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of other inputs.

ii) This function assumes constant returns to scale.

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iii) There is a problem of measurement of capital which takes only the quantity
of capital available for production.

iv) This function assumes perfect competition in the factor market which is
unrealistic.

v) It does not fit to all industries.

vi) It is based on the substitutability of factors and neglects complementarily of

factors.

vii) The parameters (A, a and ẞ) cannot give proper and correct economic
implications.

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 2) Constant Elasticity of Substitution (CES)
Production Function:
The constant elasticity of substitution production function was established by
Arrow, Chenery, Minhas and Solow. This function includes three variables, i.e.,
Q, K and L and three constraints, i.e., Α, α and θ. The CES production
function is also called as Homohighplagic production function. It can be written
as:
Q = A [α C+ (1 −α) L]-1/0.
Where,
Q Total Output,
K = Capital

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L = Labour.
A = Efficiency Constraint,
α = Distribution Constraint, or Capital Intensity Factor Coefficient, and
θ = Substitution Constraint.
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3) Variable Elasticity of Substitution (VES) Production
Function:
In VES production, it is supposed that the substitution constraint (α) becomes
variable then the variable elasticity of substitution production function come
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into effect. This substitution constraint arises from the CES production
function.

VES production function is expressed in the same way as CES. Hence, both
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these functions have same properties and drawbacks. It has an additional

benefit that it is not required to fix a priority value of elasticity of substitution.

Properties of VES Production Function

i) VES fulfils the conditions of neo-classical production function,

ii) The fixed co-efficient models are contained in the VES production function,
and

iii) VES production function is common.

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 4) Fixed Proportion (or Leontief) Production
Function:
The fixed proportion production function depends on the requirements that are
used in the production process; the several factors of production which are to
be taken into consideration must be used in fixed proportion.

When larger quantity of input is available then factors of production are

needed in fixed proportion, the extra quantity will not be required. On the other
hand, when inputs are available in smaller quantity then the other inputs will
not be required.

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For example, in a process 20 labours and 8 units of capital are needed and if
the firm has 24 labours and 8 units of capital then it finds that 4 labour units
are not utilised, whereas when there are 18 labour units and only 6 capital
units are being utilised then 2 capital units will be treated as unemployed. It
can be expressed as follows:
X = Minimum ( 𝐾
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,
𝐿
)
𝑎 𝑏
Where,
X = Total Output
K and L = Units of Capital and Labour respectively
a and b Constants
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The word 'minimum' means that the output X is based on the smaller of the
two ratios given in the bracket.
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5) Linear Programming Production Function:

The inputs in terms of factors of production are not completely fixed and they
do not change constantly. Hence, the input and output both can change in a
number of ways. This is seen by linear programming function and it is
expressed as follows:
Maximise X = a1 X₁ + a2 X2 + ... + anXn
Where,
X1, X2,..., X = Outputs
a1, a2,..., an = Constants

It is concluded from the above equation that the firms, availability helps in the
determination of some input and capacity parameters according to the budget

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Laws of Production

1) Law of Variable Proportions Analysis: Under the law of variable

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proportions, some factor quantities are kept fixed while the quantities of other
factors may be changed as per the requirements.

2) Optimum Combinations of Inputs/Isoquant Analysis: This

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production function deals with two variable inputs.

3) Return to Scale Analysis: Under this type of analysis, the quantities

of all factors may be changed.
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Meaning and Definition of Law of Variable
Proportions
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In law of variable proportions, some inputs in short run are kept fixed in their
proportion due to technical complexity in the production. There are chances
that such proportions and quantities may be changed in long run to alter the
composition of output. It is also called the production function with one
variable input or return to factor. Law of returns is now known as the Law of
Variable Proportions.
The law deals with production or defines the connection between input and
output where one factor is variable while other are fixed, leading to the change
in proportion of fixed factor and variable factor.

According to F. Benha, "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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According to G.J. Stigler "As equal increments of one input are added,
the inputs of other productive services being held constant, beyond a certain
point the resulting increments of product will decrease, i.e., the marginal
product will diminish".

Assumptions of Law of Variable Proportions

➢ One factor is variable while other factors remain constant.

➢ The variable factor has homogeneous units.

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➢ The technology remains same.

➢ The proportion of various inputs in the mix may be changed.

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➢ The law is applicable only in short run, as all factors are variable in
nature in long run.

➢ Physical units such as tonnes, kilos are used for measuring the
products. Monetary value is ignored.
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Concept of Product:
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Product or output refers to the volume of goods produced by a firm or an

industry during a specified period of time,

➢ Total Product
➢ Marginal Product
➢ Average Product

Total Product:

● Refers to total quantity of goods produced by a firm during a given

period of time with given number of inputs.
● Also known as:
Total physical product, Total return, Total output
● Example: If 10 labours produce 60 kg of rice, total product is 60 Kg

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 TP= TP1 + TP2 + TP3…………….TPn
Or
TP= ∑ MP

Average Product:

● Refers to output per unit variable input.

● Per unit production of the variable factor
● Also known as Average Physical Product, Average Return
● Example: If TP is 60 Kg of rice, produced by 10 labours (variable input),
then average product will be 60/10 = 6 kg

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𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 (𝑇𝑃)
● Average Product (AP) = 𝑈𝑛𝑖𝑡𝑠 𝑜𝑓 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐹𝑎𝑐𝑡𝑜𝑟 (𝑛)

● TP in terms of AP will be:

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TP= AP x Units of Variable Factor

Marginal Product:

● Refers to addition to total product, when one more unit of variable factor
is employed.
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MPn = TPn - TPn-1
Where,
MPn = Marginal product of nth unit of variable factors
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TPn = Total product of n units of variable factors

TPn-1 = Total product of (n-1) units of variable factors
n= number of units of variable factors

● Example: If 10 labours make 60 Kg of rice and 11 labours make 67 kg of

rice, then MP of 11th labour will be:
MP11 = TP11 - TP10
MP11 = 67-60
=7 kg

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Three Stages of Law of Variable Proportions
The stages of law of variable proportions or the stages of law of diminishing
returns are as follows:

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Law of Increasing Returns
At stage 1, total product increases at an accelerating rate to a certain point.
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Concurrently, there is also increase in marginal product and reaches its
highest point at I (Point of inflexion). However, after reaching this point, the
total product keeps on increasing, but the rate of increase slows down.
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Marginal product remains positive but slows down. At the end of stage 1,
Average Product curve is at the highest. In short, stage 1 shows that AP curve
increases during the entire stage, but marginal product curve increases and
then decreases after touching the top.

❖ Reasons behind Increasing Returns to a Factor

1) Under Utilisation of Fixed Factors: Initially, some quantity of fixed

factors of production may remain unused, which may become productive with
the introduction of additional units of variable factors of production. The full
use of fixed factors of production leads to higher and increasing returns.

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2) Indivisibility of Factors: In many cases, fixed factors of production are
indivisible in nature. This implies that irrespective of quantity of output to be
produced, there are certain minimum numbers of inputs which require to be
used. This may lead to underutilisation of such fixed factors of production.

3) Specialisation and Division of Labour: There are certain activities

leading to better and efficient use of variable factors of production.
This happens because augmentation of variable factors of production
increases the chances of specialisation and division of labour.
According to Mrs Robinson, there will be less use of time, tools, training,
etc., due to the perfect specialisation of factors which means only one factor is
specialised in one job. The law of increasing return exists due to the saving

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done.

Law of Diminishing Returns

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The total product in stage 2 keeps on increasing at a diminishing rate until it
reaches the maximum point M at the end of stage 2. There is continuous
decrease in marginal product and average product during this stage. It is an
important stage as the firm tries to produce within its limit.
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❖ Reasons for Law of Diminishing Returns

1) Certain Factors Remain Fixed: The various factors of production are

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limited in their supply. This feature may cause imbalance in the proportion of
various inputs thus the production will fail to grow at an increasing rate. This
anomaly causes the law of diminishing return to operate..

2) Certain Factors Become Scarce: There are certain factors of

production which are generally variable in nature may become fixed in certain
circumstances. For example, during a certain time period, there may be
paucity of factors of production such as skilled labour. Such paucity leads to
the operation of the law of diminishing returns.

3) Lack of Perfect Substitution of Factors of Production: There are

certain factors of production which do not have a perfect substitute. If such
factors are scare, this may cause loss of efficiency which ultimately leads to
diminishing returns.

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 ❖ Importance of the Law of Diminishing Returns

1) Universal: The law of diminishing returns is universal in nature, which

implies that it is applicable everywhere. There is a saturation point for all the
production units and it is not possible to increase production beyond that
point. Some factors are fixed in nature while others are scarce. This factor is
also operative behind the law of diminishing returns.

2) Basis for the Theory of Distribution: Marginal Productivity Theory of

Distribution also employs this law and states that the marginal productivity of
successive units of factors of production decreases.

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3) Importance of Industries: This law is essential for manufacturing
industries to estimate about the optimal production. Previously, it was just
applicable to the agricultural sector. But now its applications are improved in
industries due to industrialisation.
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Law of Negative Returns
At stage 3, there is a decline in all respect, i.e., total product (TP) marginal
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product (MP) and Average Product (AP). This stage is termed as stage of
negative returns.
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❖ Following are the main reasons behind the application of

law of negative returns:

1) Reduction in Variable Factor: The quantity of variable factors may

increase excessively in proportion to the fixed asset, causing the rate of
production gain to falls. In such cases, the quantity of variable factors of
production may be reduced to boost up the overall production.

2) Moving Beyond Optimum Level: When the plant reached at a level

where all inputs are utilised to their maximum limit, the further movement will
result in under-utilisation of inputs. This will result in decreased efficiency and
losses.

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 Difference Between Total Marginal And Average

Total Product Marginal Product Average Product

Stage 1: Increases at Increases and reaches Increases (but slower
an increasing rate. its maximum. than MP).

Stage 2: Increases at a Starts diminishing and Starts diminishing.

diminishing rate and becomes equal to zero.
reaches its maximum
point.

Stage 3: Reaches its Keeps on declining and Average product keeps

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maximum, becomes becomes negative. on declining, but it
constant and then starts remains positive or
declining. always greater than
zero.
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Meaning and Definition of Economies of
Scale
Advantages arising because of production at large scale are termed as
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'Economies of Scale' which are basically economies of production at large
scale.

The idea of increasing efficiencies of production of goods as increase in the

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number of goods is economies of scale. Average production cost of goods

typically diminishes alongwith additional production. This is because, fixed
costs of production are shared over the additional goods produced.
In micro-economics, economies of scale are defined as 'advantages in terms
of cost' that is attained by business because of expansion. There are certain
factors which help in reducing the producer's average cost per unit with an
increase in scale of output.

"Economies of scale" can be explained as deduction in cost per unit as the

facility size and the level of usage of other inputs increase and it is a concept
of long-run.

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Because of economies of scale, the large companies have great market
access in terms of media selection to access those markets, and also they
can capture larger geographical area. Returns to scale are also determined by
the economies of scale.

According to Porter, Economies of scale is the "declines in the unit's cost

of production".

According to Pratten, Economies of scale is the "reduction in average unit

costs attributable to increases in the scale of output".

According to Spencer, "Economies of scale is a curvilinear relationship

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between average cost and the number of units produced".

Internal economies of scale :-

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➢ Lower long run average costs resulting from a firm growing in size.

➢ They refer to economies that are unique to a firm. For instance, a firm
may hold a patent over a mass production machine, which allows it to
lower its average cost of production more than other firms in the
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industry.

External economies of scale :-

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➢ Lower long run average costs resulting from an industry growing in size.

➢ They refer to economies of scale faced by an entire industry.

➢ For instance, suppose the government wants to increase steel

production. In order to do so, the government announces that all steel
producers who employ more than 10,000 workers will be given a 20%
tax break.

➢ Thus, firms employing less than 10,000 workers can potentially lower
their average cost of production by employing more workers.

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 ➢ This is an example of an external economy of scale one that affects an
entire industry or sector of the economy.

Types of Internal economies of scale

1) Buying economies
2) Selling economies
3) Managerial economies
4) Financial economies
5) Technical economies
6) Research and development economies

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7) Risk-bearing economies.

Buying Economies
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➤ These are the best known type.

➤ Large firms that buy raw materials in bulk and place large orders for capital
equipment usually receive a discount.
➤ This means that they have paid less for each item purchased.
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➤ They may receive a better treatment because the suppliers will be anxious
to keep such large customers.
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Selling Economies

➤ Every part of marketing has a cost particularly promotional methods such

as advertising and running a sales force.

➤ Many of these marketing costs are fixed costs and so as a business gets
larger, it is able to spread the cost of marketing over a wider range of products
and sales cutting the average marketing cost per unit.

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 Managerial Economies

➤ As a firm grows, there is greater potential for managers to specialize in

particular tasks (e.g. marketing, human finance). resource management,

➤ Specialist managers are likely to be more efficient as they possess a high

level of expertise, experience and qualifications compared to one person in a
smaller firm trying to perform all of these roles.

Financial economies

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➤ Many small businesses find it hard to obtain finance and when they do
obtain it, the cost of the finance is often quite high.
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➤ This is because small businesses are perceived as being riskier than larger
businesses that have developed a good track record.

➤ Larger firms therefore find it easier to find potential lenders and to raise
money at lower interest rates.
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Technical Economies

➤ Businesses with large-scale production can use more advanced machinery

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(or use existing machinery more efficiently).

➤ This may include using mass production techniques, which are a more
efficient form of production.

➤ A larger firm can also afford to invest more in research and development.

Research and development economies

➤ A large firm can have a research and development department, since

running such a department can reduce average costs by developing more
efficient methods of production and raise total revenue by developing new
products.

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 Risk-bearing economies

➤ Larger firms produce a range of products.

➤ This enables them to spread the risks of trading.

➤ If the profitability of one of the products it produces falls, it can shift its
resources to the production of more profitable products.

External economies of scale

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➤ A skilled labour workforce-: A firm can recruit workers who have been
trained by other firms in the industry.
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➤ A good reputation-: An area can gain a reputation for high quality
production.

➤ Specialist suppliers of raw materials and capital goods- When an

industry becomes large enough, it can become worthwhile for other industries,
called subsidiary industries to set up for providing for the needs of the industry.
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➤ Specialist services-: Universities and colleges may run courses for workers
in large industries and banks and transport firms may provide services,
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specially designed to meet the particular needs of firms in the industry.

➤ Specialist markets-: Some large industries have specialist selling places

and arrangements such as corn exchanges and insurance markets.

➤ Improved infrastructure-: growth of an industry may encourage a govt.

and private sector firms to provide better road links, electricity supplies, build
new airports and develop dock facilities.

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Economies of Scope
Economies of scope is an economic concept that refers to the cost
advantages gained by a company or organization when it produces multiple
products or offers a variety of services together. In other words, it is the
efficiency and cost savings achieved when a business diversifies its product or
service offerings under a single operational umbrella. Economies of scope are
different from economies of scale, which focus on cost advantages achieved
by increasing the quantity of a single product or service.
With economies of scope, a company can reduce its average production costs
by sharing resources, knowledge, and capabilities across different product
lines or services. This allows the company to capitalize on synergies and

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operate more efficiently than if it were producing each product or service
independently.

Examples of economies of scope include:

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1) A food company that produces a variety of food products, such as
snacks, beverages, and frozen meals, can share production facilities,
distribution networks, and marketing efforts, resulting in cost savings.

2) A financial institution that offers banking, insurance, and investment

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services can leverage customer data and administrative functions
across these divisions, leading to cost efficiencies.
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3) A media conglomerate that owns multiple television channels, radio

stations, and publishing outlets can benefit from shared content
production, advertising sales, and promotional activities.

Features of Economies of Scope

1) The term 'economies of scope' usually involves the reduction of per-unit
costs by involving in production of different variety of goods or services.

2) The economies of scope usually exist due to the cost-savings arising from
by-products of the production process.

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3) A firm will involve in the production of the complementary products only
when producing them together is more cost effective than producing them
separately.

4) The economies of scope attract the attention of management towards the

direct and indirect benefits related to individual lines of business.

Condition of Economies of Scope

(Multi-Product Firms)

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The most important condition for the occurrence of economies of scope is the
ability of the firm to produce two or more products at a rate cheaper than
produced by two separate firms.
For example, a single firm can produce the output quantity (Q1, Q2) at a
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cheaper rate than two individual firms if following condition is satisfied:
C(Q1, Q2) <C(Q1, 0) + C(0, Q2)

Where,
Q1, Q2 = Output Level
C(Q1, Q2) = Cost Function
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In contrast to this, when a single firm is producing the output at a more

expensive rate than two individual firms then such situation is known as
diseconomies of scope. In other words, diseconomies will occur when
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following condition is satisfied:

C(Q1, Q2) > C(Q1, 0) + C(0, Q2)

Importance of Economies of Scope

1) Enables the Firms to earn Competitive Advantage:
A firm can gain a major competitive advantage with the help of economies of
scope because besides reducing expenses on a per-unit basis and increasing
profitability, these drive the less cost-efficient competitors out of the industry
and put the barrier for the new competitors to enter the market.

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2) Allow the Conversion of Superior Skill into the Production of
Complementary Products:
With the help of economies of scope, a firm can convert its superior skills of
producing a given product line into significant benefits of producing the
complementary products.

3) Facilitates International and Regional Variations:

Many a times, the customer demand may change from one region to another
or from one country to another. With the help of economies of scope, a firm
can produce varied and customised products depending upon the demand in
international and regional markets.

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Potential Problems of Economies of Scope
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1) Less Knowledge in New Products:
Sometimes it may be harmful to extend the product lines because a firm
needs to have some specialised knowledge about the new products and
absence of such knowledge makes the firm to suffer losses.

2) Damage to Brand Name:

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It is not every time beneficial to diversify the product line because any mistake
can put adverse impact on the brand image. In other words, the economies of
scope can make a firm "Jack of all trades, master of none".
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3) Potential Diseconomies of Scale:

The economies of scope may result in potential diseconomies of scale by
increasing the size of the firm. If a firm increases its size due to economies of
scope without diligently analysing it then it may become difficult to manage
and coordinate the different groups of product.

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