Production Function, ISO-quants and Economies of scale

Production
Production refers to creation of something
tangible which can be used to satisfy
human want.
However, matter already exists, we cannot
create it. Hence
The process of addition of utilities to the
existing matter by changing form, place and
keeping it over time is referred to as
Production in Economics.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Production
The process of addition of utilities to the existing
matter by changing form, place and keeping it
over time is referred to as Production in
Economics.
Technologically, however, production is referred to as a
process of transforming inputs into outputs.
This is accomplished by use of factors of production
such as Land, Labour, Capital and Organization.
These factors are inputs and finished products are
outputs.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

• Infosys Technology has taken 1 Lakh sq feet

space in IT park , Pune on lease from
Maharashtra IT development center. Co will
incur lease rent irrespective of activity at this
space. Whether the Co completes thousand
projects from this space or none, it has to pay
lease rent.
• If Infosys gets projects from 25 Fortune 500
companies , it will hire 100 software
professionals for this project.
Chapter Eight Managerial Economics
 Production Function, ISO-quants and Economies of scale

• Crude oil is a basic input for the refinery

for producing different petroleum products
like petrol, diesel, polymar etc
• SAIL using iron ore to make steel
• Flipkart taking orders and tranporting it
from one place to another
• TATA Co storing tea leaf for future
production
Chapter Eight Managerial Economics
 Production function
Is an equation ,table ,graph showing maximum output
That can be produced per time period with each set of
inputs, technology assumed to be constant.
Q= f(N,L,K,O) +(T,M)
Objective – To find the level of technical & economic
efficiency.
 Production Function, ISO-quants and Economies of scale

Short–run vs. Long-run Production Function

► The short-run is that period of time in which
at least one of the factors of production
remains fixed. Whereas, the long-run is that
period of time in which all factors are
variable.
► When one or more inputs remain constant
we consider that period of time as short period,
whereas when all inputs are capable of being
varied that period is regarded as long period.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Laws of Returns and Returns to Scale

A : Laws of Returns

or the Law of Variable proportions, clearly explains

the relationship between the inputs and the output
in the process of production.

The Law examines the production function with

only one factor variable, keeping quantities of other
factors constant.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Laws of Returns and Returns to Scale

A : Laws of Returns

Comprises of three phases :-

[a] the Law of Increasing Returns.

[b] the Law of Constant Returns.
[c] the Law of Diminishing Returns.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Laws of Returns or the Law of variable

proportions

Comprises of three phases :-

- stage of Increasing Returns.
- stage of Constant Returns.
- stage of Diminishing Returns.
- Stage of negative returns

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Seeds per Total Product Marginal Average

acre (kg) of wheat (kgs) product of Product of
wheat (kgs) wheat (kgs)

0.1 10 10 10
0.2 25 15 12.50
0.3 50 25 16.60
0.4 96 46 24
0.5 130 34 26
0.6 155 25 25.80
0.7 160 05 22.85
0.8 140 -20 17.50
0.9 110 -30 12.20

Chapter Eight Managerial Economics

 Law of Returns-variable
proportions
Seeds Total Product Ave rage Product Marginal
( kgs = TP÷ n product =
Δ TP ÷ Δ n
1 96

2 130

3 155

4 160

5 140
 Numericals

Fact TP AP MP Factor TP AP MP
or 1 6
1 4 2 11
2 7 3 15
4 18
3 9

4 10
 Production Function, ISO-quants and Economies of scale

Laws of Returns and Returns to Scale

A : Laws of Returns
If in any process of production, the factors of
production are so combined that if the varying
quantity of one factor is combined with fixed
quantity of other factors, then there will be three
tendencies about the additional or marginal output.
Firstly – in the beginning as more and more units of
variable factor are added to the units of fixed factor,
the additional output will go on increasing.
Here we have the Law of Increasing Returns in
operation.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Laws of Returns and Returns to Scale

A : Laws of Returns
If in any process of production, the factors of production are
so combined that if the varying quantity of one factor is
combined with fixed quantity of other factors, then there will
be three tendencies about the additional or marginal output.
Secondly – if still more units of variable factor
inputs are added to the units of fixed factor, the
additional output or marginal returns will remain
constant.
Here we have the Law of Constant Returns in
operation.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Laws of Returns and Returns to Scale

A : Laws of Returns
If in any process of production, the factors of production are
so combined that if the varying quantity of one factor is
combined with fixed quantity of other factors, then there will
be three tendencies about the additional or marginal output.
Finally – if still more units of variable factor inputs
are fed into the process of production then, the
additional output or marginal returns begin to
decline with the stage of Diminishing Returns in
operation.
Further use of inputs would generate negative
returns
Chapter Eight Managerial Economics
 Understanding of the law of
Returns
For most production processes if managers
add equal increments of an input while
holding other input levels constant, the
incremental gains(MP) to output gets
smaller, and if pushed to the extreme are
counter-productive. Choosing the optimal
input bundle is not an easy task .
Managers cannot hold all inputs but one
constant .
Chapter Eight Managerial Economics
 Production Function, ISO-quants and Economies of scale

Laws of Returns to Scale – Long run

Returns to Scale
In the process of production, when all the inputs
can be varied in equal proportion then the relation
between factor inputs and the output gives rise to
returns to scale.
Returns to scale become relevant only in the long
period when all the inputs can be varied
simultaneously in the same ratio.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Laws of Returns and Returns to Scale

B : Returns to Scale
The ratio of proportionate change in output to a
proportionate change in inputs is called the
production function Є.
Δq/q
i.e. Є = where Δq/q is proportionate
Δn/n change in output and
Δn/n is proportionate change in all inputs.

Chapter Eight Managerial Economics

 Law of Returns to Scale

The proportionate change in Output due to

proportionate change in Inputs
Increasing Returns - % change in Q > %
change in I
Constant Returns - % change inQ = %
change in I
Decreasing Returns - % change inQ< %
change in I
 Production Function, ISO-quants and Economies of scale

• Reliance Infocomm is a leading player in

Mobile based services and the recent
launch of Jio -4G services has increased
its revenue manifold.
• Co is increasing fund deployment and
manpower by 10% production of Rs 110 cr
and 5500 employees respectively. It has
clocked 8 million consumers across India

Chapter Eight Managerial Economics

 Law of Returns to Scale
• A 10% increase in inputs by Co A which
comprises of Capital investment of Rs
100 crore and employees strength of 5500
resulting in following production
percentages
• 10 % in Plant 1
• 6.25% in Plant 2
• 25% in Plant 3
Chapter Eight Managerial Economics
 Production Function, ISO-quants and Economies of scale

Laws of Returns and Returns to Scale

B : Returns to Scale
The ratio of proportionate change in output to a proportionate
change in inputs is called the production function Є.
Δq/q
i.e. Є =
Δn/n
if [i] Є > 1, we have Increasing Returns to Scale.
[ii] Є = 1, we have Constant Returns to Scale.
[iii] Є < 1, we have Decreasing Returns to Scale.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

The Cobb Douglas Production Function

The Cobb Douglas Production Function is a

Linear Homogeneous Production function
implying constant Returns to Scale.

It takes the form Q = A.Lα .K 1- α

Where Q stands for the Output, L & K
are inputs (labour &capital), A is a positive
constant, and α is positive fraction i.e. α < 1.
If A =10 , α = 0.5 , β =0.5 than it exibits Cobb douglas production
function.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

The Cobb Douglas Production Function

The Cobb Douglas Production Function is a
Linear Homogeneous Production function
implying constant Returns to Scale.

It shows that elasticity of substitution equals one,

It hints that if one of the input is zero, the output
also will be zero.
It is criticized as it considers only two factors,
ignores diminishing returns, assumes a] capital
input ( which is subject to depreciation) can be
measured, b] prevalence of perfect competition and
c] all the units of labour to be homogeneous.

Chapter Eight Managerial Economics

 Producer’s Equilibrium
Isoquant- It is a locus of points
showing that different combinations of
factor inputs give the same quantity of
output.
Isocost – It reflects the investment outlay of
the producer along with the prices of
factors used in production

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale
ISO-Quant or Equal Product Curve.
The iso-product map consists of two ( or more ) iso-quant curves
representing various (15 & 20 )units of output.

The Iso-product Map

30
25
20 25 q
Factor Y

15 20 q
10 15 q
5
0
1 2 3 4 5 6
Factor X

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

ISO-Quant or Equal Product Curve.

Marginal Rate of Technical Substitution
►The iso-quant curve shows that, with different
combinations of factors, we get the same output. It
necessarily implies that, factors of production are
substituting each other. This rate, at which one factor
input is substituted by the other, is called the Rate of
Technical Substitution.
► The Marginal Rate of Technical Substitution is
calculated by finding out how many of factor Y units are
substituted by addition of one unit of factor X.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

ISO-Quant or Equal Product Curve.

Marginal Rate of
Technical Substitution

ΔY

i.e. MRTS =
ΔX

It must be noted that the MRTS goes on

diminishing, giving rise to the Principle of
Diminishing Marginal Rate of Technical
Substitution. And negative slope to iso- quant
curve.
Chapter Eight Managerial Economics
 Production Function, ISO-quants and Economies of scale

ISO-Quant or Equal Product Curve.

Properties of Iso-quant.

◘ The iso-quant curve must slope downward from left to right.

If the curve was to have positive scope and

move upwards from left to right, with addition of
one unit of factor X, more units of factor Y will
be there in the new combination, More units of
X as well as Y would yield MORE and not the
same output which is the requirement of the
iso-quant.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

ISO-Quant or Equal Product Curve.

Properties of Iso-quant.

◘ The iso-quant curve must be convex to the point of origin.

If the curve was to be concave,

with addition of one unit of
factor X, more units of factor Y
will be there in the new
combination, defeating the
Principle of Diminishing Marginal
Rate of Technical Substitution.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

ISO-Quant or Equal Product Curve.

Properties of Iso-quant.

◘ No two iso-quant curves should intersect.

If the iso-quant curves of 15 units and, say,

20 units were to intersect, the same
combination of X and Y factors would yield
output of 15 and 20 units!
This is not possible, hence no two iso-quant
curves can intersect.

Chapter Eight Managerial Economics

 Find the marginal rate of technical
substiution
Capital 140 134 120 100 60 40

Labor 10 20 50 60 90 150

MRTS

Chapter Eight Managerial Economics

 Select the least cost production technique from the given
schedule , given Rent per capital unit as Rs 500 and wages
per unit of labour as RS 400
Combination Capital (K) Labour (L) Capital cost Labour cost Total cost

A 6 10

B 2 14

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Producer’s Equilibrium : The point of Least Cost Factor

Combination

A ISO Cost Line

Factor
Y

B X

Factor X

Chapter Eight Managerial Economics

 Producer’s equilibrium
Given a set of isoquants and the budget
line , producer will try to seek the highest
isoquant in the given isocost. Thus the
producer will attain equilibrium when
isocost is tangent to the isoquant

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Producer’s Equilibrium : The point of Least Cost Factor

Combination

Producer's Equilibrium

30
25
20 25 q
A
Factor Y

15 20 q
10 E 15 q
5
0 B
1 2 3 4 5 6
Factor X

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Producer’s Equilibrium : The point of Least Cost Factor

Combination
When we superimpose the iso-quant map on the
Iso- cost line in the next slide , we observe that
certain iso-quants lie above the cost line, so they
are beyond the economic reach of the producer e.g.
25 q . Some iso-quant lies below the cost line, e.g.
15, but this iso-quant will not exhaust his funds
fully.
At point E , the iso-cost line is a tangent to the iso-
quant 20q providing highest output within the cost
line. Thus the tangency between iso-cost line and
iso-quant represents the point of producer’s
equilibrium.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Economies and Diseconomies :

In the process of production firm

enjoys certain advantages and
experiences certain disadvantages.
These could be due to scale of operation or
due to its location.
They affect cost of production favorably or
unfavorably.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Economies and Diseconomies :

Those advantages or disadvantages
that accrue to a firm from within, as a
result of scale of operation are referred to
as Internal Economies and
Diseconomies;
whereas those advantages or
disadvantages that accrue to a firm from
outside and faced by the industry as a
whole are referred to as External
Economies and Diseconomies
respectively.

Chapter Eight Managerial Economics

 Economies of scale
• INTERNAL • EXTERNAL
• 1) Technical • 1) Concentration
• 2) Managerial • 2) Information
• 3) Commercial • 3) Disintegration
• 4) Financial
• 5) Risk-bearing
 Diseconomies of scale
• INTERNAL • EXTERNAL
• 1) Efficiency to • 1) Excessive
Inefficiency concentration
• 2) Administrative • 2) Labour unrest
difficulties. • 3) power,raw material
• 3) Industrial unrest shortages.
• 4) High cost of • 4) over-crowding &
reconversion unhygenic conditions
• 5)Greater risks
 Production Function, ISO-quants and Economies of scale

Economies and Diseconomies :

Those advantages or disadvantages
that accrue to a firm from within, as a
result of scale of operation are referred to
as Internal Economies and
Diseconomies;
whereas those advantages or
disadvantages that accrue to a firm from
outside and faced by the industry as a
whole are referred to as External
Economies and Diseconomies
respectively.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Economies and Diseconomies :

Internal Economies – are those advantages
which a firm enjoys from within itself by way
of reduction in its average cost of
production as its scale of operation
expands.
They are categorized into :
Technical, managerial, commercial,
financial and risk-bearing.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Internal Economies :
Technical Economies – are those advantages which
a firm enjoys from large scale of operation like

1. Division and specialization of labour

2. Utilization of specialized machinery
3. Research and training
4. Utilization of bigger machines with high initial
cost but low operating cost
5. Mechanical advantages
6. Linking processes.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Internal Economies :
Managerial Economies – are those advantages
which a firm enjoys from large scale of
operation like

1. Appointment of experts as function heads.

2. Division of each department into independent
sections.
3. Total division of labor in management

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Internal Economies :
Commercial Economies – are those advantages which
a firm enjoys from large scale of operation like

1. Buying large quantities and gaining best prices

and terms.
2. Greater quantity of goods can be sold at a little
extra cost.
3. Many products are made and sold, one product
acts as an advertisement for other products.
4. Expert sales, purchase heads are employed.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Internal Economies :
Financial Economies – are those advantages which a
firm enjoys from large scale of operation like

1. Lower interest rates.

2. Credit and finance at better terms and
conditions .
3. Facility to offer better security.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Internal Economies :
Risk-bearing Economies – are those advantages
which a firm enjoys from large scale of
operation like

1. Strength to meet variations in demand

2. Chance to develop different markets for its
products
3. Obtaining materials from various sources.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Internal Diseconomies :

The disadvantages accruing to the firm when it

produces the output beyond a particular point,
resulting in an increase in the average cost of
production are termed as diseconomies of
scale.
All economies of scale are converted into
internal diseconomies, once the output crosses
optimum level.

These are discussed next.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Internal Diseconomies :

Efficiency to Inefficiency:
Once the output crosses optimum level,
mismanagement creeps in, supervision
becomes in effective.

Administrative difficulties.
With expansion, administration becomes
unwieldy and impersonal. Problems of
competition, coordination and control are
experienced.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Internal Diseconomies :

Industrial Unrest.
Contact between workers & management is
lost. Atmosphere of discontent, distrust and
frustration sets in.

High cost of Reconversion.

Initial high cost in fixed assets becomes
irredeemable. Management is unable to
produce required goods.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

Internal Diseconomies :

Enhancement of Risks.
In case of any interruptions , standing costs
are very high. Large inventory is locked up,
huge wage cost has to be incurred. Trained
workers leave.

Increasing costs.
The high demand for materials, capital labour
results in high cost in procuring them. Output
beyond optimum level is inefficient and sub-
standard.
Chapter Eight Managerial Economics
 Production Function, ISO-quants and Economies of scale

External Economies :

External Economies are those advantages which accrue

indirectly and externally from the growth, not in the size
of the firm, but in the size of the industry as a whole.

Economies of Concentration :- since many

firms are located in one region, labour is
available with desired skill regularly; common
services are there in plenty; training , research,
ancillary centers are located nearby, reputation
is automatically earned.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

External Economies :

External Economies are those advantages which accrue

indirectly and externally from the growth, not in the size
of the firm, but in the size of the industry as a whole.

Economies of Information :- workers doing

same type of job come together to share their
experience and knowledge. Data on effective
techniques and methods is circulated.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

External Economies :

External Economies are those advantages which accrue

indirectly and externally from the growth, not in the size
of the firm, but in the size of the industry as a whole.

Economies of Disintegration :- firms do not

have to make each part , they can be bought as
firms in the Region specialize in parts in which
they hold competence.

Chapter Eight Managerial Economics

 Production Function, ISO-quants and Economies of scale

External Diseconomies :
Excessive concentration or localization of
industries results in diseconomies for the
firms within that region.
Diseconomies of concentration are
reflected in excessive pressure on
transport., high cost of scarce land,
shortage of skilled labour, militant labour
unions, scarcity of power and raw materials
etc.
The region gets polluted, over crowded and
unhygienic.

Chapter Eight Managerial Economics