BEFA UNIT III

PRODUCTION

Production is the transformation or conversion of resources into commodities over time. Economists view
production as an activity through which utility is created or enhanced for a product. A firm is a business unit
which undertakes the activity of transforming inputs into output of goods and services.

FACTORSOFPRODUCTION

Factors of production is an economic term that describes the inputs that are used in the production of goods or
services in order to make an economic profit. The factors of production include land, labor, capital and
entrepreneurship. These production factors are also known as management, machines, materials and labor, and
knowledge has recently been talked about as a potential new factor of production.

1. Land

Landis short for all the naturalresourcesavailable to create supply. It includes raw land and anything that comes
from the land. It can be a non-renewable resource.

That includescommoditiessuch as oil and gold. It can also be a renewable resource, such as timber. Once man
changes it from its original condition, it becomes a capital good. For example, oil is a natural resource, but
gasoline is a capital good. Farmland is a natural resource, but a shopping center is a capital good.

Theincomeearnedbyownersoflandandotherresourcesiscalledrent.

2. Labour

Laboris the work done by people. The value of labor depends on workers' education, skills, and motivation. It
also depends on productivity. That measures how much each hour of worker time produces in output.

Therewardorincomeforlaboriswages.

3. Capital

Capital is short for capital goods. These are man-made objects like machinery, equipment, and chemicals, that
are used in production. That's what differentiates them from consumer goods. For example, capital goods
include industrial and commercial buildings, but not private housing. A commercial aircraft is a capital goodbut
a private jet is not.

Theincomeearnedbyownersofcapitalgoodsiscalled interest.

4. Entrepreneurship

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 BEFA UNIT III
Entrepreneurshipis the drive to develop an idea into a business. An entrepreneur combines the other three
factors of production to add to supply. The most successful are innovative risk-takers.

Theincomeentrepreneursearnisprofits.

PRODUCTIONFUNCTION

The production function expresses a functional relationship between physical inputs and physical outputs of a
firm at any particular time period. The output is thus a function of inputs. So, production function is an input –
output relationship. Mathematically production function can be written as Q= Output
f=Functionof
L1= Land
Q=f(L1,L2 C,O,T)
L2=Labour
C= Capital
Here output is the function of inputs. Hence output becomes the dependent variable O=Organization T
= Technology
andinputs are the independent variables.

Definition:

Samuesondefinestheproductionfunctionas“Thetechnicalrelationshipwhichrevealsthemaximum amount
of output capable of being produced by each and every set of inputs”

MichaelRBayedefinestheproductionfunctionas”Thatfunctionwhichdefinesthemaximumamount of
output that can be produced with a given set of inputs.”

Assumptions:

Productionfunctionhasthefollowingassumptions.

1. Theproductionfunctionisrelatedtoaparticularperiodof time.
2. Thereisnochangeintechnology.
3. Theproducerisusingthebesttechniquesavailable.
4. Thefactorsofproductionare divisible.
5. Productionfunctioncanbefittedtoashortrunortolong run.

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 BEFA UNIT III
PRODUCTIONFUNCTIONWITHONEVARIABLEINPUT

The law of variable proportions which was earlier called as “Law of diminishing returns has
played a vital role in the modern economics theory. Assume that a firms‟ production function consists of fixed
quantities of all inputs (land, equipment, etc.) except labour which is a variable input. If you go on adding the
variable input, say, labor, the total output in the initial stages will increase at an increasing rate, and after
reachingcertainlevelofoutputthetotal output willincreaseatdecliningrate.If variablefactorinputsare added further
to the fixed factor input, the total output may decline. This law is of universal nature and it proved to be true in
agriculture.

AssumptionsoftheLaw:Thelawisbaseduponthefollowingassumptions:

1. Onlyonefactorisvaried
2. Thescaleofoutputisunchanged
3. Thetechniqueofproductionis unchanged
4. Allunitsoffactorinputvariedarehomogeneous
Threestagesoflaw:
The behaviour of the Output when the varying quantity of one factor is combined with a fixed quantity of the
other can be divided in to three district stages. The three stages can be better understood by following the table.

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 BEFA UNIT III

Fromtheabovegraphthelawofvariableproportionsoperatesinthreestages.Inthefirststage, total
product increases at an increasing rate. The marginal product in this stage increases at an increasing rate
resulting in a greater increase in totalproduct. The average product also increases. This stage continues up tothe
point where average product is equal to marginal product. The law of increasing returns is in operation at this
stage. The law of diminishing returns starts operating from the second stage onwards. At the second stage total
productincreases onlyata diminishingrate.Theaverage productalso declines.Thesecondstage comes to an end
where total product becomes maximum and marginal product becomes zero. The marginal product becomes
negative in the third stage. So the total product also declines. The average product continues todecline.

We can sum up the above relationship thus when „AP‟ is rising, “MP‟ rises more than “AP; When „AP” is
maximumandconstant,„MP‟becomesequalto„AP‟when„AP‟startsfalling,„MP‟fallsfasterthan„AP‟.

Thus, the total product, marginal product and average product pass through three phases, viz., increasing
diminishingandnegativereturnsstage.Thelawofvariableproportionisnothingbut thecombinationofthelaw of
increasing and demising returns.

PRODUCTIONFUNCTIONWITHTWOVARIABLEINPUTS

Isoquants analyse and compare the different combinations of capital & labour and output. The term isoquanthas
its origin from two words “iso” and “quantus”. „iso‟ is a Greek word meaning „equal‟ and „quantus‟ is a
Latinwordmeaning„quantity‟.Isoquant therefore, means equal quantity. Anisoquantcurve istherefore called as
iso-product curve or equal product curve or production indifference curve.

Thus, an isoquant shows all possible combinations of two inputs, which are capable of producing equal or a
given level of output. Since each combination yields same output, the producer becomes indifferent towards
these combinations.

Assumptions:

1. Thereareonlytwofactorsofproduction,viz.labourand capital.
2. Thetwofactorscansubstituteeachotheruptocertainlimit
3. Theshapeoftheisoquantdependsupontheextentofsubstitutabilityofthetwoinputs.
4. Thetechnologyisgivenoveraperiod.

For example:- Now the firm can combine labor and capital in different proportions and can maintain specified
level of output say, 10 units of output of a product X. It may combine alternatively as follows:

Inthebelowtable,combination„A‟represent1unitofcapitaland10unitsoflabourandproduces„10‟unitsof a product.
All other combinations in the table are assumed to yield the same given output of a product say „10‟ units by
employing any one of the alternative combinations of the two factors labour and capital. If we plot all these
combinations on a paper and join them, we will get a curve called Iso-quant curve as shown below.

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 BEFA UNIT III
Labour is on the X-axis and capital is on the Y-axis. IQ is the Iso-Quant curve which shows all the alternative
combinations A, B, C, D which can produce 10 units of a product.

Featuresofan ISOQUANT:

1. Downward sloping:-If one of the inputs is reduced, the other input has to beincreased.
There is no question ofincrease in both the inputs to yield a given output.

2. Don’t touch the axes:- The isoquant touches neitherX-axis nor Y-axis, as both inputs
are required to produce a given product.If an isoquant is touching the X-axis, it means
output is possible even by using a factor(Ex: Labor alone without using capital). But,
this is unrealistic.

3. Don’t intersect:- Iso-quants representing different levels of output never intersect or

touch or be tangent to each other. If they intersect to each other, they have a common
point on them which means that the same amount of labor and capital produce two
different levels of output.

4. Convex to origin:-Isoquants are convex to the origin. It is because the inputs factorare
not perfect substitutes. One input factor is substituted by other input factor in a
decreasingmarginalrate.Theconvexityofisoquant suggeststhatMRTSisdiminishing
which means that as quantities of one factor-labor is increased , the less of another
factor-capital will be given up, if output level is to be kept constant.

5. Upper isoquants represent higher level of output:- Each isoquant represents a

different quantity of output. Higher isoquants indicate a higher level of output.

LAWOFRETURNSTOSCALE

The concept of variable proportions is a short-run phenomenon as in these period fixed

factors cannot be changed and all factors cannot be changed. On the other hand in the long-term all factors can
be changed as made variable. When we study the changes in output when all factors or inputs are changed, we

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 BEFA UNIT III
study returns to scale. An increase in the scale means that all inputs or factors are increased in the same
proportion. In variable proportions, the cooperating factors may be increased or decreased and one faster (Ex.
Land in agriculture (or) machinery in industry) remains constant so that the changes in proportion among the
factors result in certain changes in output. In returns to scale, all the necessary factors or production are
increased or decreased to the same extent so that whatever the scale of production, the proportion among the
factors remains the same.

Assumptions

1. Techniqueofproductionisunchanged
2. Allunitsoffactorsare homogeneous
3. Returnsaremeasuredinphysicalterms

Whenafirmexpands,itsscaleincreasesallitsinputsproportionally,thentechnicallytherearethree possibilities.

1. Law of increasing returns to scale:- if a proportionate/percentage increase

intheoutput islarger thantheproportionate/percentageincrease ininputs,there are
increasing returns.

Forexample:Ifa5%increaseininputs,resultsin10%increaseinthe output, a firm is

said to attain increased returns.

IfPFC>1,itmeansincreasingreturnstoscale If
PFC = 1, it means constant returns to scale
IfPFC<1,it meansdecreasingreturnsto scale

2. Law of constant returns to scale:- if the proportionate increase in all the inputs
is equal to the proportionate increase in output, then situation of constant returns to
scale occurs.

For Example:- If the inputs are increased at 10% and if the resultant output also
increases a 10% then the organization is said to achieve constant returns to scale.

3. Law of decreasing returns to scale:- if the proportionate increase in output is

less than the proportionate increase in input, then a situation ofdecreasing returnsto
scale occurs.

ForExample:-Iftheinputsareincreasedby10%andiftheresultantoutput
increasesonlyby5%thentheorganizationissaidtoachievedecreasingreturnsto

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 BEFA UNIT III
scale.

thefollowingtableillustratestheselaws clearly.

From the above table it is clear that with 1 unit of capital and 3 units of labor, the firm produces 50 units of
output. When the inputs are doubled 2 units of capital and 6 units of labor, the output has gone up to 120 units.
Thus when inputs are increased by 100%, the output has increased by 140%. That is , output has increased by
more than double. This is governed by law of increasing returns to scale.

Whentheinputsare further doubled that is to4 units of capital and 12 unitsoflabor, the output has gone to240
units. Thus, when inputs are increased by 100%., the output has increased by 100%. That is, output hasdoubled.
This governed by law of constant returns to scale.

When the inputs further doubled, that is, to 8 units of capital and 24 units of labor, the output has gone up to360
units.Thus, when inputsareincreased by100%,the output hasincreasedbyonly50%.Thisis governedby law of
decreasing returns to scale.

DIFFERENTTYPESOFPRODUCTIONFUNCTIONS

1. Cobb-DouglasProductionFunction

This production function was proposed by C. W. Cobb and P. H. Dougles. This famous statistical
production function is known as Cobb-Douglas production function. Originally the function is applied on the
empirical study of the American manufacturing industry from 1899 to 1922. Cobb – Douglas production
functiontakesthefollowing Q=Totalproduction/Output
mathematicalform. a=Totalfactorproductivity/Multi-factorproductivity
(The ratio of output to the sum of associated labor and capital
inputs).Productivityismeasureofefficiencyoflabor/machinesetc,in
Q =aLbKC converting input into output.
𝐎𝐮𝐩𝐮𝐭
𝐅𝐚𝐜𝐭𝐨𝐫𝐩𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐯𝐢𝐭𝐲=
𝐅𝐚𝐜𝐭𝐨𝐫𝐢𝐧𝐩𝐮𝐭
𝐓𝐨𝐭𝐚𝐥𝐎𝐮𝐩𝐮𝐭
Q=1.01L0.75K0.25 𝐓𝐨𝐭𝐚𝐥𝐅𝐚𝐜𝐭𝐨𝐫𝐏𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐯𝐢𝐭𝐲=
𝐓𝐨𝐭𝐚𝐥𝐢𝐧𝐩𝐮𝐭𝐬
L = Index of employment of labor = Labour units
The above production function shows K=Indexofemploymentofcapital=Capitalunits
that 1% change in labor input, capital b = Output elasticity of labor (1% change in labor results in b% changein
output)
remainingthesame,isassociatedwitha c=Outputelasticityofcapital(1%changeincapitalresultsinc%change in
output)
0.75percentchangeinoutput.
Similarly,1%changeincapital,laborremainingthesame,isassociatedwitha0.25percentchangein output.

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 BEFA UNIT III
Assumptions:
Ithasthefollowingassumptions
1. Thefunctionassumesthatoutputisthefunctionoftwofactorsviz.capitalandlabour.
2. Itisalinearhomogenousproductionfunctionofthefirst degree
3. Thereareconstantreturnstoscaleb+c=1
4. Allinputsare homogenous
5. Thereisperfectcompetition
6. Thereisnochangeintechnology
7. BothL&KshouldbepositivefortoQtoexist.Ifeitheroftheseiszero,Qwillbezero.This implies that both
labor and capital will be combined to get output.

2. LeontiefProductionFunction:

Leontief production function, also known as FixedProportion Production Function, uses fixed proportion of
inputs having no substitutability between them. It is regarded as the limiting case for constant elasticity of
substitution.

Theproductionfunctioncanbeexpressedasfollows:

Where,q=quantityofoutputproduced Z1 =

utilized quantity of input 1

Z2=utilizedquantityofinput2 a
and b = constants

For example, tyres and steering wheels are used for producing cars. In such a case, the production function can
be as follows:

Q=min(z1/a,Z2/b)
Q=min(numberoftyresused,numberofsteeringwheelsused).

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 BEFA UNIT III
Suppose that the inputs "tires" and "steering wheels" are used in the production of a car (for simplicity of the
example, to the exclusion of anything else). Then in the above formula qrefers to the number of cars produced
i.e., one in our example, z1refers to the number of tires used, and z2refers to the number of steering wheelsused.
Assuming that each car is produced with 4 tires and 1 steering wheel, the Leontief production function is

Numberofcars=Min{¼timesthenumberoftires,1timesthenumberofsteeringwheels}.

In the above given figure, OR shows the fixedTyres-Wheels ratio, if a firmwants to produce 1 car,then 4tyres
and 1 wheel must be used.

Similarly, for the production of 3 cars and 4 cars, 12 tyres and 3 wheel and 16 tyres and 4 wheel must be
employed respectively.

3. CESProductionFunction

Definition:TheConstantElasticity of SubstitutionProductionFunctionor CES implies,thatanychangein the

input factors, results in the constant change in the output. In CES, the elasticity of substitution is constant and
may not necessarily be equal to one or unity.

In constant elasticity of substitution production function, all the input factors are taken into the consideration
such as raw material, technology, labor, capital, etc. The marginal product of one factor increases with the
increase in the value of the other factors of production. Also, the marginal product of labor and capital will be
positive in case of constant returns to scale.
Theconstantelasticityofsubstitutionproductionfunctioncanbeexpressedalgebraicallyas:

𝑸= 𝑨[𝜶𝑲−𝜷+(𝟏−𝜶)𝑳−𝜷]−𝟏/𝜷

Where,Q=output,K=CapitalandL=Labor

A=efficiencyparameterthatshowstheorganizationalaspectsofproductionandthestateoftechnology.

The Constant elasticity of substitution production function shows, that any change in the technology or
organizational aspects, the production function changes with a shift in the efficiency parameter.

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 BEFA UNIT III
α= distribution parameter or capital intensity factor coefficient concerned with relative factors in the totaloutput.

β=substitutionparameter,thatdeterminestheelasticityofsubstitution

The homogeneityof the productionfunction can bedetermined bythe value of the substitution parameter (β), if it
is equal to one, then it is said to be linearly homogeneous i.e. the proportionate change in the input factors
results in the increase in the output in the same proportion.

The homogeneityof the production function can bedetermined bythe value of the substitution parameter (β), if it
is equal to one, then it is said to be linearly homogeneous i.e. the proportionate change in the input factors
results in the increase in the output in the same proportion.

Forexample:

Considerthefollowingproductionfunction.

Q=5K+10L

Itmeans1unit Kproduces5unitsand2unitsofLproduce10units.

If we assume that, initially K = 1, L = 2, the total output may be obtained by substituting 1 for K and 2 for L in
the below equation. Thus,

Qx1=5(1)+10(2)

25 =5 +20

wheninputsaredoubled(i.e.,K=2andL=4). Then,

Qx2=5(1x2)+10(2x2) 50

= 10 + 40

Thus,thegivenproductionfunctions,wheninputsaredoubled,theoutputisalsodoubled.

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 BEFA UNIT III
TYPESOFCOSTS

Profits are the difference between selling price and cost of production. In general the selling price is not within
the control of a firm but many costs are under its control. The firm should therefore aim at controlling and
minimizing cost. The various relevant concepts of cost are:

1. OpportunitycostsandOutlay costs:

Opportunity costs refer to the „costs of the next best alternative foregone‟. We have scarce resources
and all these have alternative uses. Where there is an alternative, there is an opportunity to reinvest the
resources. In other words, if there are no alternatives, there are no opportunity costs. It is necessary that we
should always consider the cost of the next best alternative foregone before committing the funds on a given
option. In other words, the benefits from the present option should be more than the benefits of the next best
alternative. Opportunity cost is said to exist when the resources are scarce and there are alternative uses forthese
resources.If there is no alternative, Opportunity cost is zero.

For example: if a firm owns a land, there is no cost of using the land (i.e., the rent) in firm‟s account.
Bust the firm has an opportunity cost of using this land, which is equal to the rent foregone by not letting the
land out on (the return of second best alternative is regarded as the cost of first best alternative) rent.

Out lay costs are as actual costs which are actually incurred by the firm. these are the payments made
for labour, material, plant, building, machinery traveling, transporting etc., These are all those expenses
appearing in the books of account, hence based on accounting cost concept.

2. ExplicitcostsandImplicitcosts:

Explicit costs are also called as out-of-pocket cost that involve cash payments. These are the actual or
business costs that appear in the books of accounts. These costs include payment of wages and salaries,payment
for raw-materials, interest on borrowed capital funds, rent on hired land, Taxes paid etc.

Implicit costs are also called as imputed costs which don‟tinvolve payment of cash as they are not
actually incurred. They would havebeen incurred had the owner not been in possession of the facilities. Ex:
Interest on own capital, saving in terms of salary due to own supervision and rent of own building etc.

3. HistoricalcostsandReplacementcosts:

Historicalcostistheoriginalcostthathasbeenoriginallyspenttoacquiretheasset.ofanasset.
Historicalvaluationisthebasisforfinancial accounts.

Areplacement cost is the price that is to be paid currentlyto replacethe same asset. Areplacement cost is
a relevant cost concept when financial statements have to be adjusted for inflation.

4. Short–runcostsandLong–runcosts:

Short-run is a period during which the physical capacity of the firm remains fixed. Any increase in
output during this period is possible only by using theexisting physical capacitymore extensively. So short run
cost is that which varies with output when the plant and capital equipment are constant.

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 BEFA UNIT III
Long run is defined as a period of adequate length during which a company may alter all factors of
production with high degree of flexibility.

5. Out-ofpocketcostsandBooks costs:

Out-of pocket costs also known as explicit costs are those costs that involve current cash paymentsuch
as purchase of raw material, payment of salary rents payment, interest on loan etc.

Book costs also called implicit costs do not require current cash payments. Depreciation, unpaid
interest, salary of the owner is examples of back costs.

6. Fixedcosts,VariablecostsandSemi-variablecosts:

Fixed cost is that cost which remains constant for a certain level to output. It is not affected by the
changes in the volume of production but fixed cost per unit decreases, when the production is increased. Fixed
cost includes salaries, Rent, Administrative expenses depreciations etc.

Variableisthat whichvariesdirectlywiththevariationinoutput.Anincreaseintotal output resultsin an

increase in total variable costs and decrease in total output results in a proportionate deccease in the total
variables costs. The variable cost per unit will be constant. Ex: Raw materials, labour, direct expenses, etc.

Semi-variablecostsrefertosuchcoststhatarefixedtosomeextentbeyondwhichtheyarevariable.Ex: telephone
charges, Electricity charges, etc.

7. PastcostsandFuturecosts:

Past costs also called historical costs are the actual cost incurred and recorded in the book of account
these costs are useful only for valuation and not for decision making.

Future costs are costs that are expected to be incurred inthe futures.Theyare not actual costs. Theyare
the costs forecasted or estimated with rational methods. Future cost estimate is useful for decision making
because decision are meant for future.

8. SeparablecostsandJoint costs:

The costs which canbe traced or identified directly with a particular unit, department, or a process of
production are called separable costs or direct costs or traceable costs.

The costs which cannot be identified directly with a particular unit, department or a process of the
production are called joint costs or indirect costs or common costs. These costs are apportioned among various
departments. Ex: Rent, Electricity, Administration salaries, Research and Development expenses etc.

9. AvoidablecostsandUnavoidablecosts:

Avoidable costs are those costs, which can be reduced if the business activities of a concern are
curtailed. For example, if some workers can be retrenched with a drop in production, the wages of the
retrenched workers are escapable costs.

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 BEFA UNIT III
Unavoidable costsarethose thatareessential for the sustenance ofthebusiness activityand hence they
have to be incurred.

10. ControllablecostsandUncontrollablecosts:

Controllable costs are ones, which can be regulated by the executive who is in charge of it. Direct
expenses like material, labour etc. are controllable costs.

Some costs are not directly identifiable with a process of product. They are apportioned to various
processes or products in some proportion. These apportioned costs are called uncontrollable costs.

11. IncrementalcostsandSunkcosts:

Incremental cost also known as differential cost is the additional cost due to a change in the level or
nature of business activity. The change may be caused by adding a new product, adding new machinery,
replacing a machine by a better one etc.

Sunk costs are those which are not altered byany change – They are the costs incurred in the past.This
cost is the result of past decision, and cannot be changed by future decisions. Investments in fixed assets are
examples of sunk costs. Once an asset is bought, the funds are blocked forever. They can neither be changednor
controlled.

12. Totalcosts,AveragecostsandMarginalcosts:

Total cost is the total expenditure incurred for the input needed for production. It may be explicit or
implicit. It is the sum total of the fixed and variable costs.

Average cost is the cost per unit of output. It is obtained by dividing the total cost (TC) by the total
quantity produced (Q)

Marginalcostistheadditionalcostincurredtoproduceanadditionalunitof output.

13. AccountingcostsandEconomic costs:

Accounting costs are the costs recorded for the purpose of preparing the profit & loss account and
balancesheettomeetthelegal,financialandtaxpurposeofthecompany.Theaccountingconceptisahistorical concept
and records what has happened in the post.

Economic cost refers to cost of economic resources used in production including opportunity cost.
Economics concept considers future costs and future revenues, which help future planning, and choice, whilethe
accountant describes what has happened, the economics aims at projecting what will happen.

14. UrgentcostsandPostponablecosts:

Urgentcostarethosecostssuchasrawmaterials,wagesandson,necessarytosustainthe productivity.

Postponable costs are those costs which can be conveniently postponed. For example, white washingthe
building etc.

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 BEFA UNIT III
COST-OUTPUTRELATIONSHIP

The cost-output relationship plays an important role in determining the optimum level of production.
Knowledge of the cost-output relationship helps the manager in cost control, profit prediction, pricing,
promotionetc. Outputisanimportantfactor,whichinfluencesthecost.Consideringtheperiodthecost function can be
classified as (a) short-run cost function and (b) long-run cost function. In the short run, the costs can be
classified intofixed costs and variable costs.The cost-output relationshipin the shortrunis governedbycertain
restrictions in terms of fixed costs whereas in the long run, the cost-output relationship studies the effect of
varying the size of plants upon its cost.

I. Short-runCostFunction:

Under short run cost-output relation, costs in short run are classified into fixed costs and variable costs.
Labour is the variable factor while capital is the fixed factor. Total fixed cost remains constant while variable
cost changes with the variation in units if labour. The fixed costs may be ascertained in terms of total fixed cost
and average fixed cost per unit. The variable cost can be determined in terms of average variable cost, total
variable cost. The below table explains the behavior of costs in the short run. From the below it is clear that:

Total

 Totalfixedcostsremainfixedirrespectiveofincreaseordecreaseinproductionactivity.
 Average fixed cost per unit declines as the volume of production increases. As production increases, the
fixed costs are spread over a great number of units. There is inverse relationship between average fixed
cost and volume of production.
 The total variable cost increases proportionately with production. But, the rate of increase is notconstant.
 Thetotalcostincreaseswiththevolumeofproduction.
 The average total cost decreases up to certain level of
production. After this level, it rises steeply. It results in flat
U-shaped curve. The lowest point of AFC curve denotes the
ideal level of production.
 Marginal cost is the change in total cost due to one unit
change in output.

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 BEFA UNIT III
Theshort-runcost-outputrelationshipcanbeshowngraphicallyasfollows.

 Fromthis graph, it is noticed that as the production increases, the AFC will continue to decrease. Hence,
the AFC curve will slope downwards and it appears to meet the X axis but it never meets the X axis.
 The AVC curve is U-shaped curve indicating that the AVC curve tends to fall in the beginning when
outputincreasesbutafteraparticular levelofoutput,itrisesbecauseoftheapplicationoflawofreturns or law of
variable proportions or law of diminishing returns.
 The ATC curve initially declines and then rises upward. As long as AVC declines the ATC will also
decline.
 MC is the change in total cost resulting from a unit change in output. It decreases up to certain level of
output but later rises steeply.

II. Long-runCostFunction:

Long run refers to that period of time over which all factors are variable. It has no fixed cost. Overa
long period, the size of the plant can be changed, unwanted buildings can be sold staff can be increased or
reduced. The long run enables the firms to expand and scale of their operation by bringing or purchasing larger
quantities of all the inputs. Thus in the long run all factors become variable.

In the long run a firm has a number of alternatives in regards to the scale of operations. For each
scale of production or plant size, the firm has an appropriate short-run average cost curves. The short-run
average cost (SAC) curve applies to only one plant whereas the long-run average cost (LAC) curve takes in to
consideration many plants.

If we assume that there are many plant sizes, each suitable for a certain level of output, we will get many SAC
curves intersecting each other. As the number of plant sizes increases, the points of intersection of SAC curve
will come closer. And, if we assume that there are large number (say, infinite number) of plant sizes the
intersectionpointswill be so near to each other thatweget almosta continuouscurve. Thus continuous curve is
known as the Long-run Average Cost (LAC) curve or the Envelope curve (as it envelopes the family of short-
run Average Cost Curves).

Thelong-runcost-outputrelationshipisshowngraphicallywiththehelpof“LCA‟curve.

The above figure shows how LAC curve envelopesseveral

short-run average cost (SAC) curves. Suppose,the firm is
producing an output of OQ1 units on a plant of
SAC1,ifitwantstoproduceOQ2 units of output, either
itcanoperateonSAC1byoverutilizingSAC1plantorby
acquiring a bigger size palntSAC2 and operate on it. Itwill
be less costly to operate on SAC2. If it wants to
produceOQ3 units of output, it can operate on the bigger
size plant SAC3 at least cost. Q3A3 is the
leastcostattheoutputOQ3andthefirmattainsoptimum

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 BEFA UNIT III
output in the long-run at OQ3 level of output. If it operates on SAC2 to produce OQ3 units of output, the cost
will be prohibitively high being Q3A33. It is to be notes that there is only one short-run average cost curve
SAC3 which is tangential to the long-run average cost curve at its minimum point. All other SAC curves are
tangential to the LAC curves at higher than their minimum average cost points.

MARKET
Market is a place where buyer and seller meet, goods and services are offered for the sale and transfer of
ownership occurs. A market may be also defined as the demand made by a certain group of potential buyers for
a good orservice.The former one is anarrow conceptand later oneisa broader concept. Economistsdescribe a
market as a collection of buyers and sellers who transact over a particular product or product class (the housing
market, the clothing market, the grain market etc.). For business purpose we define a market as people or
organizations with wants (needs) to satisfy, money to spend, and the willingness to spend it. Broadly, market
represents the structure and nature of buyers and sellers for a commodity/service and the process by which the
price of the commodity or service is established. In this sense, we are referring to the structure of competition
and the process of price determination for a commodity or service. The determination of price for a commodity
or service depends upon the structure of the market for that commodity or service (i.e., competitive structure of
the market). Hence the understanding on the market structure and the nature of competition are a pre-requisitein
price determination.
DifferentMarketStructures
Marketstructuredescribesthecompetitiveenvironmentinthemarketforanygoodorservice.Amarket consists of all
firms and individuals who are willing and able to buy or sell a particular product. This includes firms and
individuals currently engaged in buying and selling a particular product, as well as potential entrants.
Thedeterminationofpriceisaffectedbythecompetitivestructureofthemarket.Thisisbecausethefirm operates in a
market and not in isolation. In making decisions concerning economic variables it is affected, asare all
institutions in society by its environment.

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 BEFA UNIT III
PERFECTCOMPETITION
Perfect competition refers to a market structure where competition among the sellers and buyers prevails in its
most perfectform. In a perfectlycompetitive market, asingle market priceprevailsfor thecommodity, whichis
determined by the forces of total demand and total supply in the market.
CharacteristicsOfPerfectCompetition
Thefollowingfeaturescharacterizeaperfectlycompetitivemarket:
a) A large number of buyers and sellers: Thenumberofbuyersandsellersislargeandtheshareofeach one of
them in the market is so small that none has any influence on the market price.
b) Homogeneousproduct:Theproductofeachselleristotallyundifferentiatedfromthoseofthe others.
c) Freeentryandexit:Anybuyerandsellerisfreetoenterorleavethemarketofthe commodity.
d) Perfectknowledge:Allbuyersandsellershaveperfectknowledgeaboutthemarketforthe commodity.
e) Indifference:Nobuyerhasapreferencetobuyfromaparticularsellerandnosellertoselltoa particular buyer.
f) Non-existenceoftransportcosts:Perfectlycompetitivemarketalsoassumesthenon-existenceof transport
costs.
g) Perfect mobility of factors of production: Factors of production must be in a position to move freely
into or out of industry and from one firm to the other.
Perfectcompetition:Theindividualfirm
AR(Average revenue) curve and MR(Marginal Revenue) curve under perfect competition becomes equal to
D(Demand) curve and it would be a horizontal line or parallel to the X-axis. The curve simply implies that a
firmunderperfectcompetitioncansellasmuchquantityasitlikesatthegivenpricedeterminedbytheindustry
i.e.aperfectlyelasticdemand curve.

Perfectcompetition:Thefirmandtheindustry
Price is determined by the market forces, that is, demand and supply for a given product or service. Asdiscussed
above, firms have no control over the prices they charge for their products. The ultimate price that determines
the quantity demanded is equal to the quantity supplied. This price is also called equilibrium price, as it
balances the forces of demand and supply. The figure shows how the price is determines. DD is thedemand
curve and SS is the supply curve. Rs. 6 is the price at which DD and SS intersect each other. At Rs. 6, 60 units
are supplied and demanded.
IfthepriceincreasestoRs.8,supplywillalsoincreaseandhencethepriceislikelytofalldown.

17
 BEFAUNIT III
IfthepricedecreasestoRs.4,supplywilldecreaseandhencethepriceislikelytogoup.

Price-OutputDeterminationUnderPerfectCompetition
In this market, the price is determined by supply and demand forces. Marshal who propounded the theory says
that the price is determined by the equilibrium between demand and supply.
The pricing of commodity under perfect competition can be determinedin
three periods of time.
a) Veryshortperiod(Market Period)
Market period is too short period to increase the supply. The market
period is so short that supply of the commodity is limited to existing stock.During
the market period, say a single day, the supply of a commodity isperfectly
inelastic.
In this figure quantity is represented along X-axis and price
isrepresentedalongY-axis.MSistheveryshortperiodsupplycurve.DDis
demandcurve. It intersectssupplycurveat E.ThepriceisOP.ThequantityisOM.D1D1representsincreased demand.
This curve cuts the supply curve at E1. Even at the new equilibrium, supply is OM only. But price increases to
OP1. So, when demand increases, the price will increase but not the supply. If demand decreases new demand
curve will be D2 D2. This curve cuts the supply curve at E2. Even at this new equilibrium, the supply is OM
only. But price falls to OP2. Hence in very short period, given the supply, it is the change in demand that
influences price. The price determined in a very short period is called Market Price.
b) ShortPeriod
Short period is not too long period to install new capital
equipments.It isalsonot sufficientperiodtopermitthe newfirms toenter the
industry to increase the supply of the commodity in the market. Hence the
firm can increase the supply of a commodity in the short period only by
making intensive use of the given plants and equipments andincreasing
the units of variable factors.
As a result of this, the short period supply of a commodity will be
relatively less elastic.
 BEFAUNIT III
InthediagramMSisthemarketperiodsupplycurve.DDistheinitialdemandcurve.ItintersectsMScurveat
E. The price is OP and output OM. Suppose demand increases, the demand curve shifts upwards and becomes
D1D1. In the very short period, supply remains fixed on OM. The new demand curve D1D1 intersects MS at
E1. The price will rise to OP1. This is what happened in the very short-period.
As the price rises from OP to OP1, firms expand output. As firms can vary some factors but not all, the law of
variableproportionsoperates.Thisresultsinnewshort-runsupplycurveSS.It interestsD1D1curveat E2.The price will
fall from OP1 to OP2.
c) LongPeriod
In Long run, the Firm‟s output (supply) can be changed by both the
variable factors and fixed factors i.e. all factors become variable.There
is enough time for new Firms to enter the Industry. Further, if the
demand is increased, the supply can be increased or decreased
according to the demand. For Longrun equilibrium, long run marginal
cost (LMC) is equal to MR and LMC curve cut the MR curve from
below. In case of long run equilibrium, all the firms will earn only
normal profits.
Take the case when the Firm earn super-normal profit-Then the existingFirmwill increase their productionand
new Firm will enter the Industry. Consequently, the total supply will increase and price fall down and further
results in normal profit for the firm
On the contrary, if the firm is incurring losses, Then some Firm will leave the Industry which will reduce the
total supply. And dueto decreaseinsupply, pricewill rise and onceagain Firmwill begintoearnnormal profit. Firm
equilibrium is at the minimum point of its LAC and at this point the Firm will get the normal profits. IfAR
(price) rises to OP1, then Firm‟s LMC cuts its MR1 at E1 and the firm gets super-normal profit but again come
to OPyielding normal profits as stated before. And at price OP 2, firmincurs losses but again rise to level OP to
maintain the equilibrium at normal profit
Firm‟sequilibrium:MC=MR=AR=minLAC
MONOPOLY
„mono‟ means single and „poly‟ means seller. The term monopoly refers to that market in which a single firm
controls the whole supply of a particular product which has no close substitutes. Monopoly emerges in firms
such as transport, water and electricity supply etc.
Features:
1. Single person or a firm: A single person or a firm controls the total supply of the commodity. There
will be no competition for monopoly firm. The monopolist firm is the only firm in the whole industry.
2. No close substitute: The goods soldbythe monopolist shall not have close substitutes. Evenif price of
monopoly product increases, people will not go in far substitute. For example: If the price of electric
bulb increases slightly, consumer will not go in for kerosene lamp.
3. Large number of Buyers: Under monopoly, there maybe a large number of buyers inthe market who
compete among themselves.
4. Price Maker:Sincethemonopolistcontrolsthewholesupplyofacommodity,heisaprice-maker,and then he
can alter the price.
 BEFAUNIT III
5. Supply and Price: The monopolist can fix either the supply or the price. He cannot fix both. If he
charges a very high price, he can sell a small amount. If he wants to sell more, he has to charge a low
price. He cannot sell as much as he wishes for any price he pleases.
6. Downward Sloping Demand Curve: Thedemandcurve(averagerevenuecurve) ofmonopolistslopes
downward from left to right. It means that he can sell more only by lowering price.

Monopolyreferstoamarket situationwherethereisonlyoneseller.Hehascompletecontrol over thesupplyof a

commodity. He is therefore in a position to fix any price. Under monopoly there is no distinction between a firm
and an industry. This is because the entire industry consists of a single firm.
Beingthesoleproducer,themonopolist hascompletecontrolover thesupplyofthecommodity.Hehasalsothe power to
influence the market price. He can raise the price by reducing his output and lower the price by increasing his
output. Thus he is a price-maker. He can fix the price to his maximum advantages. But he cannot fix both the
supply and the price, simultaneously. He can do one thing at a time. If he fixes the price, his output will be
determined by the market demand for his commodity. On the other hand, ifhe fixes the output to be sold, its
market will determine the price for the commodity. Thus his decision to fix either the price or theoutput is
determined by the market demand.
The market demand curve of the monopolist (the average revenue curve) is downward sloping. Its
correspondingmarginal revenue curve is alsodownward sloping. But the marginalrevenue curve lies belowthe
average revenue curve as shown in the figure.The monopolist facesthe down-slopingdemand curve becauseto
sell more output, he must reduce the price of his product. The firm‟s demand curve and industry‟s demand
curve are one and the same. The average cost and marginal cost curve are U shaped curve. Marginal cost falls
and rises steeply when compared to average cost.
Undermonopoly,demandcurveisaveragerevenuecurve.

Price-OutputDeterminationUnderMonopoly
The monopolistic firm attains equilibrium when its marginal cost becomes
equal to the marginal revenue. The monopolist always desires to make
maximum profits. He makes maximum profits when MC=MR. He does not
increasing his output if his revenue exceeds his costs. But when the costs
exceed the revenue, the monopolist firm incur loses. Hence the monopolist
curtails his production. He produces up to that point where marginal cost is
equalto the marginal revenue (MR=MC). Thus, the point is called equilibrium
point. The price output determination under monopoly may be explained with
the help of a diagram.
 BEFAUNIT III
In the diagram, the quantity supplied or demanded is shown along X-axis. The cost or revenue is shown along
Y-axis. AC and MC are the average cost and marginal cost curves respectively. AR and MR curves slope
downwards from left to right. AC and MC are U shaped curves. The monopolistic firm attains equilibriumwhen
its marginal cost is equal to marginal revenue (MC=MR). Under monopoly, the MC curve may cut the MR
curve from below or from a side. In the diagram, the above condition is satisfied at point E. At point E,
MC=MR. The firm is in equilibrium. The equilibrium output is OM. Up to OM output, MR is greater than MC
and beyond OM, MR is less than MC. Therefore, the monopolist is will be in equilibrium at output OM where
MR=MC and profits are maximized.
Theabovediagram(Averagerevenue)=MQorOP Average
cost = MR
Profitperunit=AverageRevenue-Averagecost=MQ-MR=QR Total
Profit = QR x SR=PQRS
IfAR>AC;Abnormalorsupernormalprofits. If AR
= AC;Normal Profit
IfAR<AC;Loss
MONOPOLISTICCOMPETITION
Perfect competition and pure monopoly are rare phenomena in the real world. Instead, almost every market
seems to exhibit characteristics of both perfect competition and monopoly. Hence, in the real world, it is the
state of imperfect competition lying between these two extreme limits that work. Edward. H. Chamberlain
developed the theory of monopolistic competition, which presents a more realistic picture of the actual market
structure and the nature of competition.
Features/Characteristics
Theimportantcharacteristicsofmonopolisticcompetitionare:
1. Existence of Many firms: Industry consists of a large number of sellers, each one of whom does not
feel dependent upon others. Every firm acts independently without bothering about the reactions of its
rivals. The size is so large that an individual firm has only a relatively small part in the total market, so
that eachfirmhasverylimitedcontrol over thepriceoftheproduct.Asthenumber isrelativelylarge,it is
difficult for these firms to determine its price- output policies without considering the possible reactions
of the rival forms. A monopolistically competitive firm follows an independent price policy.
2. Product Differentiation: product differentiation is the essential feature of monopolistic competition.
Products can be differentiated by means of unique facilities, advertising, brand loyalty, packing,pricing,
terms of credit, superior maintenance service, convenient location and so on. Through heavy
advertisement budgets, Pepsi and Coca-Cola make it very expensive for a third competitor to enter the
cola market on such a big scale. The following example illustrate how the firms differentiatethemselves
from others in a monopolistic environment.
 Inhotelindustry,somehotelshavespaciousswimmingpools,gyms,culturalprogramsetc.The
customers who value these facilities don‟t bother about price changes.
 Thecollegeswhoprovidebestinfrastructureandplacementsinvariousreputedcompanies have
demand from the student community irrespective of an increase in tuition fee.
 Cellphoneswhichhaveuniquefeatureshavedemandfromthepublicevenpriceincreases.
 BEFAUNIT III
3. Large Number of Buyers: There are large number of buyers in the market. But the buyers have their
own brand preferences. So, the sellers are able to exercise a certain degree of monopoly over them.
Each seller has to plan various incentive schemes to retain the customers who patronize his products.
4. Free Entry and Exist of Firms: As in the perfect competition, in the monopolistic competition too,
there is freedom of entry and exit. That is, there is no barrier as found under monopoly.
5. Selling costs: Since the products are close substitutes, much effort is needed to retain the existing
consumers and to create new demand. So, each firm has to spend a lot on selling cost, which includes
cost on advertising and other sale promotion activities.
6. Imperfect Knowledge: Imperfect knowledge about the product leads to monopolistic competition. If
the buyers are fully aware of the quality of the product, they cannot be influenced much by
advertisement or other sales promotion techniques.
7. The Group: Under perfect competition, the term industry refers to all collection of firms producing a
homogenous product. But under monopolistic competition, the products of various firms are not
identical though they are close substitutes.
Price–OutputDeterminationUnderMonopolisticCompetition
Under monopolistic competition, Since different firms produce different varieties of products, different
prices for them will be determined in the market depending upon the demand and cost conditions. Each firmwill
set the price and output of its own product. Here also the profit will be maximized when marginal revenue is
equal to marginal costMR=MC. The demand curve for the firm in case of monopolistic competition is just
similar to that of monopoly.
The degree of elasticity of demand of a firm in monopolistic competition depends upon the extent to
which the firm can resorts to product differentiation. The greater the ability of the firm to differentiate the
product, the less elastic the demand is. The firm‟s influence to increase the price depends upon the extent to
which it can differentiate the product.
a) Short-run
In the short-run, the firm is in equilibrium when marginal Revenue =
Marginal Cost. In the figure,AR is the average revenue curve. MR
marginal revenue curve, MCmarginal cost curve, AC average cost curve,
MR and MC interest at point E where output is OM and price MQ (i.e.
OP).Thus,theequilibriumoutputisOMandthepriceisMQor OP.When the
price (average revenue) is above average cost, a firm will be making
supernormal profit. From the figure it can be seen that AR is above AC in
the equilibrium point.As AR is above AC, this firm is making abnormal
profitsintheshort-run.TheabnormalprofitperunitisQR,i.e.,the
difference between AR and AC at equilibrium point and the total supernormal profit is OR x OM. This total
abnormal profitsis represented bytherectangle PQRS. Thefirm may make supernormal profits intheshort-run if it
satisfies the following two conditions.
a) MR = MC
b) AR>AC
bLong–run
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More and more firms will be entering the market having been attracted by
supernormal profits enjoyed by the existing firms in the industry. As a result,
competition become s intensive on one hand, forms will compete with one
another for acquiring scare inputs pushing up the prices of factor inputs. On
the other hand, on the entry of several firms, the supply in the market will
increase, pulling down the selling price of the products. In order to cope with
thecompetition,thefirmswillhavetoincreasethebudget onadvertising.The
entry of new firms continue till the supernormal profits of the firms completely eroded and ultimately firms in
the industrywill earn onlynormal profits.Those firms which are not able toearnat least normal profits will get
closed. Thus in the long-run, every firm in the monopolistic competitive industry will earn only normal profits,
which are just sufficient to stay in the business. It is be noted that normal profits are part of average costs.
Inthelong-run,inordertoachieveequilibriumposition,thefirmhastofulfillthefollowingconditions:
a) MR = MC
b) AR=ACatthelevel ofequilibriumlevelofoutput.
OLIGOPOLY
The term oligopoly is derived from two Greek words, oligos meaning a few, and pollen meaning to sell.
Oligopoly is the form of imperfect competition where there are a few sellers in the market, producing either a
homogeneous product or producing products, which are close but not perfect substitute of each other.
Features
1. MonopolyPower:
There is a clement of monopoly power in oligopoly. Since there are only a few firms and each firmhas
a large share of the market. In its share of the market, it controls the price and output. Thus anoligopoly
has some monopoly power.

2. InterdependenceofFirms:
Under oligopoly, there are only a few firms, each producing a homogeneous or slightly differentiated
product. Since the number of firms is small, each firm enjoys a large share of the market and has a
significantinfluenceonthepriceandoutputdecisions.Thus,there isinterdependence offirms. No firm can
ignore the actions and reactions of rival firms under oligopoly.

3. ConflictingAttitudeofFirms:
Under oligopoly, two types of conflicting attitudes are found in the firms. On the one hand, firmsrealize
the disadvantages of mutual competition and desire to combine to maximize their joint profits. This
tendency leads to the formation of collusion. On the other hand, the desire to maximize one‟s
individual profit may lead to conflict andantagonism; the firms come into clash with one another onthe
question of distribution of profits and allocation of markets. Thus, there is an existence of two opposing
attitudes among the firms.

4. Fewfirms.Inthismarket,onlyfewsellersarefound:
For example, the market for automobiles in India exhibits oligopolistic structure as there are only few
producers of automobiles. If there are only two firms, it is called „duopoly‟.
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5. Natureofproduct:
Ifthefirmsproducthomogeneousproduct,itbecomespureoligopoly.Thefirmswithproduct differentiation constitute
impure oligopoly.

6. Interdependenceamongfirms:
In oligopoly market, each firm treats the other as its rival firm. It is for this reason that each firm while
determining price of its product, takes into account the reaction of the other firms to its own action.

7. Largenumberofconsumers:
Inthismarket,therearelargenumbersofconsumerstodemandthe product.

TYPESOFPRICING
Firms set prices for their products through several alternative means. The important pricing methods followedin
practice are shown in the chart.

A. CostBasedPricing
1. Fullcostpricing:-Underthismethod,priceisjustequaltotheaverage cost.
2. Cost plus pricing:- Here, the average cost is ascertained and then a conventional margin added to the
cost to arrive at the price. In other words, find out the product unit‟s total cost and add a percentage of
profit to arrive at the selling price. It is commonly followed in departmental stores and other retail
shops. This method is simple to be administered. It may be very difficult to find the selling price in
advance due to complexity of the nature of the project.
3. Marginal cost pricingBreak even pricing or Target profit pricing:- In thismethod, sellingpriceis
fixed in such a way that it covers full variable or marginal cost and contributes towards recovery of
fixed costs. in the stiff competition, marginal cost offers a guidelines as to how far the selling price can
be lowered.
B. Competitionbasedpricing
Here the price of product is set based on what the competitor charges for a similar product. In other words, a
reduction in the price of products by the competitor will force us to follow suit. In such a case, how far we can
go on reducing the price?. Here the marginal cost concept comes handy. As long as the price covers the
marginal cost, continue to sell. If not, better stop selling. It is because, every unit sold at less than marginal cost
results in loss.

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1. Sealed bid pricing:- This method is more popular in tenders and contracts. Each contracting firm
quotesitspriceina sealedcover called“tender”.All the tendersare openedonascheduleddateandthe person
who quotes the lowest price is awarded the contract.
2. Going rate pricing:- Here the prevailing market price is charged. Suppose, when one wants to buy or
sell gold, the prevailing market rate at a given point of time is taken as the basis to determine the price.
C. DemandBasedPricing
1. Perceived value pricing:- This method considers the buyer‟s perception of the value of the product as
the basis of pricing. Here the pricing rule is that the firm must develop procedures for measuring the
relative value of the product as perceived by consumers.
2. Price discriminationDifferential pricing:- Price discrimination refers to the practice of charging
different prices to customers for the same good.In involves selling a product or service for different
prices in different market segments. Price differentiation depends on geographical location of the
consumers, type of consumer, purchasing quantity, season, time of the service etc. E.g. Telephone
charges, APSRTC charges.
D. Strategybased pricing
1. Skimming pricing:- The company follows this method when the product is for the first timeintroduced
in the market. Under this method, the company fixes a very high price for the product. this strategy is
mostly found in case of technology products. When Samsung introduces a new cell phone model, it
fixes a high price because of the uniqueness of the product.
2. Penetration pricing:- This is exactly opposite to the market skimming method. Here, a low price is
fixed for the product in order to catch the attention of consumers, once the product image andcredibility
is established, the seller slowly starts jacking up the price to reap good profits in future. The Rin
washing soap perhaps falls into this category. This soap was sold at a rather low price in the beginning
and the firm even distributed free samples. Today, it is quite an expensive brand and yet it is selling
very well.
3. Two-part pricing:- Under this strategy, a firm charges a fixed fee for the right to purchase its goods,
plus a per unit charge for each unit purchased. Entertainment houses such as country clubs, athletic
clubs, etc, usually adopt this strategy. They charge a fixed initiation fee or membership fee plus a
charge, per month or per visit, to use the facilities.
4. Block pricing:- We see block pricing in our day-to-day life very frequently. Four Santhoor soaps in a
single pack with nice looking soap box or five Maggi packets in a single pack with an attractive bowl
indicate this pricing method. The total value of the goods includes consumer‟s surplus as the consumer
is given soap box and bowl along with the products freely. By selling certain number of units of a
product as one package, the firm earns more than by selling unit wise.
5. Commodity bundling:- Commodity bundling means the practice of bundling two or more different
products together and selling them at single „bundle price‟. For example tourist companies offer the
package that includes the travelling charges, hotel, meals and sight-seeing etc, at a bundle price instead
of pricing each of these services separately.

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6. Peak load pricing:- Under this method, high price is charged during the peak times than off-peaktimes.
RTC increases charges during festivals, Railways charge more fares during tatkal time. During seasonal
period when demand is likely to be higher, a firm may increase profits by peak load pricing.
7. Cross subsidization:- The process of charging high price for one group of customers in order to
subsidize another group.
8. Transfer pricing:- Transfer pricing means a price at which one process forwards their outputwork-in-
progress to the next process for further processing. It is an internal pricing technique.

PRODUCTLIFECYCLEBASEDPRICING

Companies must adapt to the stages of the product life cycle to effectively sell and promote their products.
Depending on the product life cycle stage, a company will develop branding techniques and an appropriate
pricing model. Understanding each stage helps businesses increase profits.

The stages of a product life cycle govern how a product is priced, distributed, and promoted. A new product
goes through multiple stages during the course of its life cycle, including an introduction stage, growth stage,
maturitystageandadeclinestage.Asaproductages,companieslookfornewwaystobrandit,andalsoexplore
pricingchanges.Market and competitor research help businesses assess the proper course of action to maintain
product profitability.

IntroductionStage
A new product may simply be either another brand name added to the existing ones or an altogether new
product. Pricing a new brand for which there are many substitutes available in market is not a big problem as
pricing a new product for which close substitutes are not available.
Therearetwotypeofpricingstrategiesfornewproduct.
1. Skimming price policy:- Selling a product at a high price, sacrificing high sales to gain a high profit,
therefore „skimming‟ the market. Usually employed to reimburse the cost of investment of the original
research into the product - commonly used in electronicmarkets when a new range, such as DVD players,
are firstly dispatched into the market at a high price.
2. Penetration price policy:- This pricing policy is adopted generally in the case of new product for which
substitutes are available. This policyrequires fixinga lowerinitial price designed to penetrate the market as
quickly as possible.

GrowthStage

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During the growth stage, a company aims to develop brand recognitionand increase their customer base. The
quality of their product is often improved based on early reviews, and technical support is usually enhanced.
Pricing remains generally stable as demand continues with minimal competition. A larger distribution network
is formed to keep up with the pace of demand.
Maturity Stage
In the maturity stage, the steady sales start to decline and companies face greater challenges in the marketplace.
Competitors will often introducerival productswith the intent of grabbingsome of the market share.Thisisthe
product life cycle stage in which the customer base is heavilyfought over and price decreases most often occur.
Additional features are added to distinguish a product from its competitors. Companies run promotions during
this stage that highlight the primary differences between their product and their competitor‟s products.

DeclineStage
In the decline stage, a company will make important decisions regarding the future of their product. They can
choose to create new iterations of the product with new features, or they can reduce the price and offer it at a
discount. A company may choose to discontinue the product altogether, either disposing of their inventory or
selling it to another company who is willing to manufacture and market it. Promotion at this stage will depend
on whether a company chooses to continue its product, and how they plan to re-market it.

BREAKEVENANALYSIS

BEP analysis is also called as CVP analysis. The BEP can be defined as that level of sales at which total
revenues equals total costs and the net income is equal to zero. This is also known as no-profit no-loss point.

Break-even analysis refers to analysis of costs and their possible impact on revenues and volume of the firm.
Hence, it is also called the cost-volume-profit (CVP) analysis. A firm is said to attain the BEP when its total
revenue is equal to total cost(TR=TC).

Themainobjectiveof theBreakEvenAnalysisisnotonlytospottheBEPbut alsotodevelopanunderstanding of the

relationships of cost, volume and price within a company‟s practical range of operations.

AssumptionsofBreak-EvenAnalysis

1. Allcostaredividedintofixedand variable
2. Fixedcostsremainconstantwhereasvariablecostsvary
3. Sellingpriceremains constant
4. Therewillbenochangeintheoperatingefficiency

KeytermsusedinBreak-evenAnalysis

1. Fixedcost(FC):- Fixedcostremainsfixedintheshort-run.Thesecostsmust bebornebythefirmever there is no

production. Example: Rent, Insurance, Depreciation, permanent employees‟ salaries. Etc. Fixed cost per
units varies.

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2. Variablecosts(VC):-Thecostswhichvaryindirectproportiontotheproduction/salesvolumearecalledas
variablecosts.variablecostperunitisfixed.Examplesforvariablecosts:costofdirectmaterial,costdirect labor,
direct expenses, operating supplies such as oil, grease etc.

3. Totalcost(TC):-Thetotaloffixedcostandvariablecosts.TC=FC+VC

4. Totalrevenue:-Thesalesamountofgoodssoldinthemarket.(SellingPriceperunitxNoofunitssold).

5. Contribution:-Theexcessofsalesrevenueovervariablecost(C=S-V).

6. P/VRatio(Profit/VolumeRatio):-Theratiobetweenthecontributionandsales:
F

7. MarginofSafetysales(M/Ssales):-Theexcessofactualtotalsalesoverbreakeven sales.

8. Break-even pointBEP:- The point where total revenue is just equal to the total cost is called Break-even
point. At break-even point, there is not profit or no loss to the business. Break-even point can be calculatedin
units as well as in sales.

𝐹
𝐵𝐸𝑃(𝑖𝑛𝑢𝑛𝑖𝑡𝑠)=
𝐶𝑝𝑒𝑟𝑢𝑛𝑖𝑡
𝐹
𝐵𝐸𝑃(𝑖𝑛𝑠𝑎𝑙𝑒𝑠)=
𝑃/𝑉𝑅𝑎𝑡𝑖𝑜
𝐹+𝐷𝑃
𝑈𝑛𝑖𝑡𝑠𝑓𝑜𝑟𝑎𝑑𝑒𝑠𝑖𝑟𝑒𝑑𝑝𝑟𝑜𝑓𝑖𝑡=
𝐶𝑝𝑒𝑟𝑢𝑛𝑖𝑡

𝐹+ 𝐷𝑃
𝑆𝑎𝑙𝑒𝑠𝑓𝑜𝑟𝑎𝑑𝑒𝑠𝑖𝑟𝑒𝑑𝑝𝑟𝑜𝑓𝑖𝑡= =𝑈𝑛𝑖𝑡𝑠 𝑓𝑜𝑟𝑑𝑒𝑠𝑖𝑟𝑒𝑑𝑝𝑟𝑜𝑓𝑖𝑡𝑥𝑆𝑃𝑝𝑒𝑟𝑢𝑛𝑖𝑡
𝑃/𝑉𝑅𝑎𝑡𝑖𝑜

Importantnotes:

 At BEP sales, Total sales=Total costF+V. At this stage, total contributionS-V is equal to fixed cost.
So, there is no profit or no loss. Hence, C=F.
 BelowtheBEPsales,totalcontributionisnotequaltototalfixedcost.Hence,C˂F.
 BeyondBEPsalesM/Ssales,sincefixedcostisrecoveredatBEPsales,C=P.
 Intotalsales, C=F+P

104
 BEFAUNIT III
 InBEPsales,C=F
 BelowtheBEPsales,C=F-P; C˂F
 InM/Ssales,C=P
 M/Ssales=Totalsales-BEP sales
 BEPsales=Totalsales-M/Ssales
 Totalsales=BEPsales+M/Ssales

WeunderstoodfromtheaboveBEPgraphthat:

 In the above figure, units of products/sales are shownon the horizontal axis OX and costs and revenues
are shown on vertical axis OY.
 Thevariablecostlineisdrawnfirst.Itincreasesalongwithvolumeofproductionand sales.
 Thetotalcostlineisparalleltovariablecostline.Itisderivedbyaddingtotalfixedcostslinetothe total variable
cost line.
 Thetotal revenueline (TR)starts frompoint (0) andincreasesalongwith volumeof production or sales
intersecting total cost line at point BEP.
 Totheright oftheBEPisprofit zoneandtotheleftoftheBEPistheloss zone.
 AperpendicularfromtheBEPto the horizontalaxisat point „M‟shows„OM‟is thequantityproduced at „
OP‟ the cost at BEP.
 The angle formed by the point of intersection of total revenue and total cost line at BEP is called angle
of incidence. The greater the angle of incidence, the higher is the magnitude of profit once the fixed
costs are observed.
 Margin of safety refers to the excess of production or sales over and above the BEP. The margin of
safety „MN‟ is the difference between ON and OM (ON-OM=MN). The sales value at ON is OQ.

SIGNIFICANCEOFBREAK-EVENANALYSIS

1) Toascertaintheprofitonaparticularlevelofsalesvolumeoragivencapacityofproduction.
2) Tocalculatesalesrequiredtoearnaparticulardesiredlevelof profit.
3) Tocomparetheproductlines,salesarea,methodofsaleforindividualcompany.
4) Tocomparetheefficiencyofthedifferentfirms.
5) Todecidewhethertoaddaparticularproducttotheexistingproductlineordroponefromit.
6) Todecideto„makeorbuy‟agivencomponentorsparepart.
7) Todecidewhatpromotionmixwillyieldoptimumsales.

105
 BEFAUNIT III
8) To assess the impact of changes in fixed cost, variable cost or selling price on BEP and profits during a
given period.

LIMITATIONSOFBREAK-EVENANALYSIS

1) Break-evenpointisbasedonfixedcost,variablecostandtotalrevenue.Achangeinonevariableis going to
affect the BEP.
2) Allcostscannotbeclassifiedintofixedandvariablecosts.wehavesemi-variablecosts also.
3) In case of multi-product firm, a single chart cannot be of any use. Series of charts have to be made use
of .
4) Itisbasedonfixedcostconceptandhence-holdsgoodonlyintheshort-run.
5) Total cost and total revenue lines are not always straight as shown in the figure. The quantity and price
discounts are the usual phenomena affecting the total revenue line.
6) Wherethebusinessconditionsarevolatile,BEPcannotgivestableresults.

PROBLEMSANDSOLUTIONS:

1. Afirmhasafixedcost ofRs.10,000,sellingpriceperunitisRs.5andvariablecostperunitisRs.3.
a. Determinebreak-evenpointintermsofvolumeandalsosales value.
b. Calculatethemarginofsafetyconsideringthattheactualproductionis8000units.
Solution:
𝐹
𝒂.𝐵𝐸𝑃(𝑖𝑛𝑢𝑛𝑖𝑡𝑠)=
𝐶𝑝𝑒𝑟𝑢𝑛𝑖𝑡

Note:BEPinunitscanbecalculatedonlywhenunitsalespriceandunitvariablecostare given.
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑝𝑒𝑟𝑢𝑛𝑖𝑡=𝑆𝑒𝑙𝑙𝑖𝑛𝑔𝑝𝑟𝑖𝑐𝑒𝑝𝑒𝑟𝑢𝑛𝑖𝑡−𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑐𝑜𝑠𝑡 𝑝𝑒𝑟𝑢𝑛𝑖𝑡=𝑆 −𝑉=5−3=2

𝐹 10000
𝐵𝐸𝑃(𝑖𝑛𝑢𝑛𝑖𝑡𝑠)= = =5000𝑢𝑛𝑖𝑡𝑠
𝐶 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 2

𝐹
𝐵𝐸𝑃(𝑖𝑛𝑠𝑎𝑙𝑒𝑠)=
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜

𝐶 2
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜= 𝑋100= 𝑋100=40%
𝑆 5

𝐹 10000
𝐵𝐸𝑃(𝑖𝑛𝑠𝑎𝑙𝑒𝑠)= = =𝑅𝑠.25000
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜 40%

(or)

𝐵𝐸𝑃 (𝑖𝑛𝑠𝑎𝑙𝑒𝑠)=𝐵𝐸𝑃𝑢𝑛𝑖𝑡𝑠𝑥𝑆𝑒𝑙𝑙𝑖𝑛𝑔𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟𝑢𝑛𝑖𝑡=5000𝑥5=25000

106
 BEFAUNIT III
𝑃
𝒃.𝑀𝑎𝑟𝑔𝑖𝑛𝑜𝑓𝑠𝑎𝑓𝑒𝑡𝑦𝒔𝒂𝒍𝒆𝒔=
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜
Profit=TotalSales–(TotalVariablecost+Fixedcost) Profit =
Contribution – Fixed cost
Contribution=Sales–Variable cost
TotalSales=TotalUnitssoldxSellingpriceperunit=8000x5=Rs.40000 Total variable
cost x Variable cost per unit = 8000 x 3 = Rs. 24000
Profit=TotalSales–(TotalVariablecost+Fixedcost)=40000–(24000+10000)=Rs.6000

𝑃 6000
𝑀𝑎𝑟𝑔𝑖𝑛𝑜𝑓𝑠𝑎𝑓𝑒𝑡𝑦𝑠𝑎𝑙𝑒𝑠= = =𝑅𝑠.15000
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜 40%

(or)
Marginofsafetysales=MarginofsafetyunitsxSellingpriceperunit
Marginofsafetyunit=Totalunits–BEPunits=8000–5000=3000
Marginofsafetysales=MarginofsafetyunitsxSellingpriceperunit=3000x5=Rs.15000

2. A high-tech rail can carrya maximum of 36,000 passengers per annumat a fare of Rs. 400. The variable cost
per passenger is Rs. 150 while the fixed costs are Rs.25,00,000 per year. Find the break-even point in terms
of number of passengers and also in terms of fare collections.
Solution:
𝐹
𝒂.𝐵𝐸𝑃(𝑖𝑛 𝑛𝑢𝑚𝑏𝑒𝑟𝑜𝑓𝑝𝑎𝑠𝑠𝑒𝑛𝑔𝑒𝑟𝑠)=
𝐶𝑝𝑒𝑟𝑢𝑛𝑖𝑡
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑝𝑒𝑟 𝑝𝑎𝑠𝑠𝑒𝑛𝑔𝑒𝑟=𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒𝑝𝑒𝑟𝑝𝑎𝑠𝑠𝑒𝑛𝑔𝑒𝑟−𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑐𝑜𝑠𝑡𝑝𝑒𝑟𝑝𝑎𝑠𝑠𝑒𝑛𝑔𝑒𝑟
=𝑆−𝑉=400− 150=250

𝐹 2500000
𝐵𝐸𝑃(𝑖𝑛𝑛𝑢𝑚𝑏𝑒𝑟𝑜𝑓𝑝𝑎𝑠𝑠𝑒𝑛𝑔𝑒𝑟𝑠)= = =10000 𝑝𝑎𝑠𝑠𝑒𝑛𝑔𝑒𝑟𝑠
𝐶𝑝𝑒𝑟𝑢𝑛𝑖𝑡 250

𝐹
𝒃.𝐵𝐸𝑃(𝑖𝑛𝐹𝑎𝑟𝑒𝑐𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛)=
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜
𝐶 250
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜= 𝑋100= 𝑋100=62.50%
𝑆 400

𝐹 2500000
𝐵𝐸𝑃(𝑖𝑛𝐹𝑎𝑟𝑒𝑐𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛)= = =Rs.4000000
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜 62.50%

3. Srikanth Enterprises deals in the supply of hardware parts of computer. The following cost data is available
for two successive periods.
YearIRs YearII Rs
Sales 50,000 1,20,000
Fixedcosts 10,000 20,000
Variablecost 30,000 60,000
Determine1.Break-even point, 2.Marginofsafety
Solution:

107
 BEFAUNIT III
𝐹
𝟏.𝐵𝐸𝑃(𝑖𝑛𝑠𝑎𝑙𝑒𝑠)=
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜

𝐶 𝑆−𝑉
P/𝑉𝑟𝑎𝑡𝑖𝑜= 𝑋100= 𝑋100
𝑆 𝑆
𝐶 𝑆− 𝑉 50000− 30000
𝑌𝑒𝑎𝑟𝐼.𝑃/𝑉𝑟𝑎𝑡𝑖𝑜= 𝑋100= 𝑋100= 𝑋100=40%
𝑆 𝑆 50000

𝐶 𝑆−𝑉 120000− 60000

𝑌𝑒𝑎𝑟𝐼𝐼.𝑃/𝑉𝑟𝑎𝑡𝑖𝑜= 𝑋100= 𝑋100= 𝑋100=50%
𝑆 𝑆 120000

𝐹 10000
𝑌𝑒𝑎𝑟𝐼.𝐵𝐸𝑃(𝑖𝑛𝑠𝑎𝑙𝑒𝑠)= = =𝑅𝑠.25000
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜 40%

𝐹 20000
𝑌𝑒𝑎𝑟𝐼𝐼.𝐵𝐸𝑃(𝑖𝑛𝑠𝑎𝑙𝑒𝑠)= = =𝑅𝑠.40000
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜 50%

𝑃
2.𝑀𝑎𝑟𝑔𝑖𝑛𝑜𝑓𝑠𝑎𝑓𝑒𝑡𝑦𝒔𝒂𝒍𝒆𝒔=
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜

Profit=TotalSales –(TotalVariablecost+Fixedcost)=S–(V+F) Year I.

Profit = S – (V + F) = 50000 – (30000+10000) = Rs. 10000 Year II.

Profit = S – (V + F) = 120000 – (60000+20000) = Rs. 40000

𝑃
𝑌𝑒𝑎𝑟𝐼.𝑀𝑎𝑟𝑔𝑖𝑛𝑜𝑓𝑠𝑎𝑓𝑒𝑡𝑦𝒔𝒂𝒍𝒆𝒔= =10000=𝑅𝑠.25000
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜 40%

𝑃
𝑌𝑒𝑎𝑟𝐼𝐼.𝑀𝑎𝑟𝑔𝑖𝑛𝑜𝑓𝑠𝑎𝑓𝑒𝑡𝑦𝒔𝒂𝒍𝒆𝒔= =40000=𝑅𝑠.80000
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜 50%

4. Fromthefollowingdata,calculate,
a. P/V Ratio, b.ProfitwhensalesareRs.20,000
Fixed expenses Rs. 4,000,Break-even point Rs. 10,000
Solution:

𝐶 𝑆−𝑉 𝐹+𝑃 𝐹 𝑃 𝑉
𝒂.𝑃/𝑉𝑟𝑎𝑡𝑖𝑜= = = = = =1−
𝑆 𝑆 𝑇𝑜𝑡𝑎𝑙𝑆𝑎𝑙𝑒𝑠 𝐵𝐸𝑃𝑠𝑎𝑙𝑒𝑠 𝑀/𝑆𝑠𝑎𝑙𝑒𝑠 𝑆
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒𝑖𝑛𝑝𝑟𝑜𝑓𝑖𝑡𝑠
=
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒𝑖𝑛𝑠𝑎𝑙𝑒𝑠

108
 BEFAUNIT III
𝐹 4000
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜= = 𝑥100=40%
𝐵𝐸𝑃 𝑠𝑎𝑙𝑒𝑠 10000

b. WhatisprofitwhentotalsalesareRs.20000?.
Totalsales=BEPsales+Marginofsafetysales
Note:-Contributionoftotalsalesincludesprofitandfixedcost.=C=(P+F) Contribution
of total sales = Total sales x P/V ratio
=20000x 40%= 8000
C= (P+F)
P=C–F =8000-4000=Rs. 4000

5. Acompanyshowsthetradingresultsfortwoperiods:
Period Sales Profit
PeriodI Rs.20,000 Rs.1000
Period II Rs. 10,000 Rs.400
Calculate P/V Ratio.
Solution:

𝐶 𝑆− 𝑉 𝐹+ 𝑃 𝐹 𝑃 𝑉
𝑃/𝑉𝑟𝑎𝑡𝑖𝑜= = = = = =1−
𝑆 𝑆 𝑇𝑜𝑡𝑎𝑙𝑆𝑎𝑙𝑒𝑠 𝐵𝐸𝑃𝑠𝑎𝑙𝑒𝑠 𝑀/𝑆𝑠𝑎𝑙𝑒𝑠 𝑆
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒𝑖𝑛𝑝𝑟𝑜𝑓𝑖𝑡𝑠
=
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒𝑖𝑛𝑠𝑎𝑙𝑒𝑠

𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 1000− 400 600

𝑃/𝑉𝑟𝑎𝑡𝑖𝑜= = = 𝑥100=6%
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒𝑖𝑛𝑠𝑎𝑙𝑒𝑠 20000− 10000 10000

ADDITIONALINFORMATION

ISOCOST

Iso-cost means the line which will show the various combinations of two inputs which can be purchased with a
given amount of total money. Suppose total amount is Rs 1000, labor cost is Rs 40 per unit, capital cost is Rs
200 per unit. Alternative combinations are as follows:
 BEFAUNIT III
Plotting these values on a graph, joining the points A,B, C, D, then, we will have an isocost line. If the level of
production changes, the total cost changes and thus the isocost curve moves upwards, and vice versa.

When outlay is increased, price of factors unchanged, factor combination will change. For each
increase in outlay, the isocost lines will be different and shifted to upward and they are parallel till
prices of factors are unchanged.

The slope of isocost line vary when factor prices vary. AB is the original isocost line. Total
outlay remaining the same, when capital price is lowered, labor price remaining unchanged, the
new isocost line A1B is drawn. Similarly, AB1 represents new isocost line when labor price is
reduced, capital price being unchanged. AB, A1B and AB1 alternative cost lines corresponding
to varying factor prices.

MARGINALRATEOFTECHNICALSUBSTITUTION(MRTS)

The marginal rate of technical substitution (MRTS) refers to the rate at which one input factor can besubstituted
with the other to attain a given level of output. The slope ofisoquant has a technical name called MRTS.

Changeinoneinput ΔK
MRTS= =
Changeinanother input ΔL
WhereΔKischangeincapitalandΔLischangeinlabor.
2− 1
MRTS= =5:1
20− 15

LEASTCOSTCOMBINATIONOFINPUTS

The manufacturer has to produce at lower costs to attain higher profits. The isocosts and isoquants can be used
to determine the inputs usage that minimizes the cost of production.

For example: Here are two input combinations for production of 100 pens.The price of capital and labor areRs 7
and 10 respectively.

The following table clarifies the combination which has least cost.The combination no. 3 with a total cost of102
represents the least cost.
 BEFAUNIT III
In our two input, one output production function, the cost equation for inputs canbe written as C = LPL +KPK
where,

C=Totalcostofinputs L
= Quantity of labor PL
= Price of labor
K=Quantityofcapital PK
= Price of capital
Thus a linear equation can be obtained for a given level of expenditure and prevailing
prices of inputs. For labor costing Rs 10 per unit and capital costing Rs 7 per unit, the
costequationbecomesC=10L+7K.IfthecompanyhasbudgetofRs70,10L+7K=70
i.e., it can buy7 units of labor with no capital or 10 units of capital with no labor or some in between
combination of labor and capital. By joining the two extreme points, we get an isocost.
Once the isocost has been developed for a particular budget, we can draw the isoquant for the required output
level on the same graph.

When the isoquant curve is superimposed on the isocost line, the point oftangency between
the isoquant and the isocost is the point of the least cost combination of inputs. At that point
A, labor and capital are combined in a proportion that maximizes the output for a given
budget

When a family of isoquants is superimposed on the various

possible budget lines(isocost lines), all the isocosts will be
tangential. We will thus have a number of least cost
combinations one each for every output level. If all the points
of tangency between the isocosts and isoquants, representing
different output levels are joined, the resultant curve is known
as an “Expansion Path”. Thus, expansion path is the locus ofall
possible least cost combinations of inputs for a production
function.

The points of tangencies a,b,c, on the isoquant curves represent the least cost combination of inputs yielding
maximum level of output.
 BEFAUNIT III
ECONOMIESOFSCALE

Production may be carriedon a small scale or o a large scale by a firm. When a firm expands its size of
production by increasing all the factors, it secures certain advantages known as economies of production.
Marshall has classified these economies of large-scale production into internal economies and external
economies.

Internal economiesresult from an increase in the scale of output of a firm and cannot be achieved unless
output increases. Hence internal economies depend solely upon the size of the firm and are different fordifferent
firms.

Externaleconomies are those benefits, which are shared in by a number of firms or industries when the scaleof
productioninanindustryor groupsofindustriesincreases.Henceexternaleconomies benefitallfirms within the
industry as the size of the industry expands.

I. Internal Economies:

A). TechnicalEconomies.

Technical economies arise to a firm from the use of better machines and superior techniques of
production. As a result, production increases and per unit cost of production falls. A large firm, which employs
costly and superior plant and equipment, enjoys a technical superiority over a small firm. This increases the
productive capacity of the firm and reduces the unit cost of production.

B). ManagerialEconomies:

Theseeconomiesariseduetobetterandmoreelaboratemanagement,whichonlythelargesizefirms can
afford. There may be a separate head for manufacturing, assembling, packing, marketing, general
administration etc. Each department is under the charge of an expert. Hence the appointment of experts,division
of administration into several departments, functional specialization and scientific co-ordination of various
works make the management of the firm most efficient.

C). MarketingEconomies:

The large firm reaps marketing or commercial economies in buying its requirements and in selling its
final products. The large firm generally has a separate marketing department. It can buy and sell on behalf ofthe
firm, when the market trends are more favorable. In the matter of buying, they could enjoy advantages like
preferential treatment, transport concessions, cheap credit, prompt delivery and fine relation with dealers.
Similarly it sells its products more effectively for a higher margin of profit.

D). FinancialEconomies:

The large firm is able to secure the necessary finances either for fixed capital purposes or for working
capital needs more easily and cheaply. It can barrow from the public, banks and other financial institutions at
relatively cheaper rates.

E). RiskbearingEconomies:
 BEFAUNIT III
As there is growth in the size of the firm, there is increase in the risk also. The firmcan insure its assets
against the hazards of fire, theft and other risks. More often, they deal in more than one product to offset the
losses by the profits from the sale of others.

F). EconomiesofResearch:

A large firm possesses larger resources and can establish its own research laboratory and employ
trained research workers. The firm may even invent new production techniques for increasing its output and
reducing cost.

G). Economiesofwelfare:

Alargefirmcanprovidebetterworkingconditionsin-andout-sidethefactory.Facilitieslikesubsidized
canteens, crèches for the infants, recreation room, cheap houses, educational and medical facilities tend to
increase the productive efficiency of the workers, which helps in raising production and reducing costs.

II. ExternalEconomies.

A). EconomiesofConcentration:

When an industry is concentrated in a particular area, all the member firms reap some common
economies like skilled labour, improved means of transport and communications, banking and financial
services, supply of power and benefits from subsidiaries. All these facilities tend to lower the unit cost of
production of all the firms in the industry.

B). EconomiesofInformation

The industry can set up an information centre which may publish a journal and pass on information
regarding the availability of raw materials, modern machines, export potentialities and provide otherinformation
needed by the firms. It will benefit all firms and reduction in their costs.

C). EconomiesofWelfare:

An 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 bodies for setting up housing colonies for the
workers.It mayalsoestablishpublichealthcareunits,educationalinstitutionsbothgeneralandtechnicalsothat a
continuous supply of skilled labour is available to the industry. This will help the efficiency of the workers.

D). EconomiesofDisintegration:

The firms in an industry may also reap the economies of specialization. When an industry expands, it
becomes possible to split up some of the processes which aretaken over byspecialistfirms. For example,inthe
cotton textile industry, some firms may specialize in manufacturing thread, others in printing, still others in
dyeing, some in long cloth, some in dhotis, some in shirting etc. As a result, the efficiency of the firms
specializing in different fields increases and the unit cost of production falls.

Thusinternaleconomiesdependuponthesizeofthefirmandexternaleconomiesdependuponthesizeof industry.
 BEFAUNIT III

DISECONOMIESOFSCALE

Internal and external diseconomies are the limits to large-scale production. It is possible
that expansion of a firm‟s output maylead to rise in costsand thus result diseconomies
instead of economies. When a firmexpands beyond proper limits, it is beyond the
capacityof the manager to manage it efficiently. This is an example of an internal
diseconomy. In the same manner, the expansion of an industry may result in diseconomies,
which may be called external diseconomies.

A). FinancialDiseconomies:

For expanding business, the entrepreneur needs finance. But finance may not be
easily available in the required amount at the appropriate time. Lack of finance retards the
production plans thereby increasing costsof the firm.

B). Managerialdiseconomies:

There are difficulties of large-scale management. Supervision becomes a difficult

job. Workers do not work efficiently, wastages arise, decision-making becomes difficult,
coordination between workers and management disappears and production costs increase.

C). MarketingDiseconomies:

As business is expanded, prices of the factors of production will rise. The cost will
therefore rise. Raw materials may not be available in sufficient quantities due to their
scarcities. Additional output may depress the price in the market. The demand for the
products may fall as a result of changes in tastes and preferences of the people. Hence cost
will exceed the revenue.

D). TechnicalDiseconomies:

There is a limit to the division of labour and splitting down of production

processes. The firm may fail to operate its plant to its maximum capacity. As a result cost
per unit increases. Internal diseconomies follow.

E). DiseconomiesofRisk-taking:

As the scale of production of a firm expands, risks also increase with it. Wrong
decision by the management may adversely affect production. If large firms are affected by
 BEFAUNIT III

any disaster, natural or human, the economy will be put to strains.