BBA Subject- Business Economics

PRODUCTION FUNCTION

1) Production is the process of conversion of inputs into outputs.

2) It is the creation of utility and addition of value
3) Production function is the relationship between inputs & output of a commodity
4) The mathematical expression of production function is –
Qx = f(x1,x2,x3,…..... xn)
Ox → Output of commodity X.
f = Function of
x1,x2,x3,… .....xn → Inputs
5) The inputs/resources used for production are called factors of production. These are namely land,
labour, capital & entrepreneur.

Attributes of production function

1. It indicates a functional relationship between physical inputs and physical outputs. For example,
if we have two factors, say, labour (L) and capital (K) then the production function
Q = f (L, K)
2. The production function is always in relation to a period of time. It denotes the flow of inputs
resulting in a flow of outputs during a particular period of time. This is due to the fact when the
firm wants to increase the production, it can either employ “some factors” additionally or
increase “all the factors” in accordance with availability of the time period. Later we will study it
as short period and long period.
3. The production function can specify either the maximum quantity of output that can be
produced by a given set of input or the minimum quantity of inputs required for producing
certain level of output.
4. The quantity of inputs is dependent upon the state of technology available and firm’s
managerial ability to use them. In order to simplify things the state of technology is considered
to be given.
5. Production function takes into account the most efficient technology and methodology available
at a time.
6. Production function is purely a technology relationship between input and output. It has
nothing to do with the nominal relationship between input and output. It has nothing to do with
the nominal price of factors; or value of quantity produced by them.

Fixed factors & variable factors:

1) Fixed Factor (FF)
a. Fixed factors refer to those factors of production which cannot be changed during short
run.
b. These are used in a fixed quantity in the short run.
c. These factors can be changed only in the long run.
d. Example-land, plant and machinery, factory building etc.
2) Variable Factor (VF)
a. Variable factor refer to those factors of production which can be changed during short
period.
b. The quantity of variable inputs varies according to the level of output.
c. Example-labour, raw material etc.

Time Element in Production Function

Short Run and Long Run
Short Run: Short refer to a period of time in which a firm cannot change its fixed factors of production
only variable factors can be changed.

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Long Run: Long run refers to a time period during which a firm can change all the factors of production.
In the long run, all inputs are variable. Therefore the distinction between fixed factors and variable
factors will disappear.

Basic Concepts of Production

1. Total product or Total physical product (TP or TPP)
Total product refers to the total volume of a commodity produced by a firm with given inputs
during a given period.
2. Average product or Average physical product (AP or APP)
Average product is per unit product of a variable input
It is obtained by dividing the total product (TP) by the units of a variable factor.
Symbolically, =
3. Marginal product or Marginal physical product (MP or MPP)
Marginal product is an addition to the total product when an additional unit of variable factor
(labour) is employed.

Law of Variable Proportions

The Law of Variable Proportions (also called as returns to factor or Laws of Returns) is discussed under
the situation of having one factor variable and another factor being used in fixed quantity if there are
only two factors of production. This alters the proportions between factors; therefore, it is called as
Law of Variable Proportions. The law is applicable for short run. Here Qx=f(L).

The law can be explained with the help of below table:

First Stage- Stage of Increasing Returns

• In this stage as the input of variable factor (labour) increases, marginal product (MP) tends to
increase and total product (TP) increases at increasing rate because there is underutilization of
the fixed input
• MP also tends to rise alongwith AP.
Second Stage- Stage of Diminishing Returns
• In this stage, increase in the input of variable factor (Labour) is followed by a decrease in MP
but it remains positive and TP increases at decreasing rate because there is pressure on fixed
input.
Third Stage- Stage of Negative Returns
• In this stage, increase in the units of variable factor (labour) renders MP negative and TP starts
declining because there is too much of variable input in relation to the fixed input.

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BBA Subject- Business Economics

THE LAWS OF RETURNS TO SCALE: PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS
The laws of returns to scale refer to the effects of a change in the scale of factors (inputs) upon output
in the long run when the combinations of factors are changed in the same proportion.
If by increasing two factors, say labour and capital, in the same proportion, output increases in exactly
the same proportion, there are constant returns to scale. If in order to secure equal increases in output,
both factors are increased in larger proportionate units, there are decreasing returns to scale. If in
order to get equal increases in output, both factors are increased in smaller proportionate units, there
are increasing returns to scale.

Increasing Returns to Scale:

Below figure shows the case of increasing returns to scale where to get equal increases in output, lesser
proportionate increases in both factors, labour and capital, are required.

It follows that in the figure:

100 units of output require 3C + 3L
200 units of output require 5C + 5L
300 units of output require 6C + 6L

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So that along the expansion path OR, OA > AB > BC. In this case, the production function is
homogeneous of degree greater than one. The increasing returns to scale are attributed to the existence
of indivisibilities in machines, management, labour, finance, etc. Some items of equipment or some
activities have a minimum size and cannot be divided into smaller units. When a business unit expands,
the returns to scale increase because the indivisible factors are employed to their full capacity.
Increasing returns to scale also result from specialisation and division of labour. When the scale of the
firm expands there is wide scope for specialisation and division of labour. Work can be divided into
small tasks and workers can be concentrated to narrower range of processes. For this, specialized
equipment can be installed.

Thus with specialization efficiency increases and increasing returns to scale follow:
Further, as the firm expands, it enjoys internal economies of production. It may be able to install better
machines, sell its products more easily, borrow money cheaply, procure the services of more efficient
manager and workers, etc. All these economies help in increasing the returns to scale more than
proportionately.
Not only this, a firm also enjoys increasing returns to scale due to external economies. When the
industry itself expands to meet the increased long-run demand for its product, external economies
appear which are shared by all the firms in the industry. When a large number of firms are
concentrated at one place, skilled labour, credit and transport facilities are easily available.
Subsidiary industries crop up to help the main industry. Trade journals, research and training centres
appear which help in increasing the productive efficiency of the firms. Thus these external economies
are also the cause of increasing returns to scale.

Decreasing Returns to Scale:

Below Figure shows the case of decreasing returns where to get equal increases in output, larger
proportionate increases in both labour and capital are required.

It follows that:
100 units of output require 2C + 2L
200 units of output require 5C + 5L
300 units of output require 9C + 9L
So that along the expansion path OR, OG < GH < HK.
In this case, the production function is homogeneous of degree less than one. Returns to scale may start
diminishing due to the following factors. Indivisible factors may become inefficient and less productive.
Business may become unwieldy and produce problems of supervision and coordination.
Large management creates difficulties of control and rigidities. To these internal diseconomies are
added external diseconomies of scale. These arise from higher factor prices or from diminishing
productivities of the factors. As the industry continues to expand the demand for skilled labour, land,
capital, etc. rises.
There being perfect competition, intensive bidding raises wages, rent and interest. Prices of raw
materials also go up. Transport and marketing difficulties emerge. All these factors tend to raise costs

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and the expansion of the firms leads to diminishing returns to scale so that doubling the scale would
not lead to doubling the output.

Constant Returns to Scale:

Below Figure shows the case of constant returns to scale. Where the distance between the isoquants
100, 200 and 300 along the expansion path OR is the same, i.e., OD = DE = EF. It means that if units of
both factors, labour and capital, are doubled, the output is doubled. To treble the output, units of both
factors are trebled.

It follows that:
100 units of output require
1 (2C + 2L) = 2C + 2L
200 units of output require
2 (2C + 2L) = 4C + 4L
300 units of output require
3 (2C + 2L) = 6C + 6L
The returns to scale are constant when internal economies enjoyed by a firm are neutralised by
internal diseconomies so that output increases in the same proportion. Another reason is the balancing
of external economies and external diseconomies.
Constant returns to scale also result when factors of production are perfectly divisible, substitutable,
homogeneous and their supplies are perfectly elastic at given prices. That is why, in the case of constant
returns to scale, the production function is homogeneous of degree one.

ECONOMIES AND DISECONOMIES OF SCALE

Economies of scale are advantages that arise for a firm because of its larger size, or scale of operation.
These advantages translate into lower unit costs (or improved productive efficiency), although some
economies of scale are not so easy to quantify.
In some markets, firms have to be of at least a certain size to be able to compete at all, because of the
minimum level of investment required; economists call this minimum efficient scale.
On the other hand, inefficiencies can also creep in because of increased size, known as diseconomies of
scale
In the correct sense of the term, economies and diseconomies of scale relate to advantages and
disadvantages of an increase in the firm’s productive capacity – such as moving to a larger factory or
installing completely new technology. Do not confuse these terms with capacity utilisation, which is
the degree to which thecurrent scale of operations is actually being used.
Economies of scale can be ‘internal’ (specific to an individual firm) or external (advantages that benefit
the industry as a whole).

The main kinds of internal Economies of Scale are:

Purchasing – firms producing on a larger scale should be able to bulk buy raw materials or product for
resale in larger quantities. They may be able to cut out wholesalers by buying direct from producers,
and transport costs per unit may also be reduced. The firm might also be buying in large enough

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quantities to make very specific demands about product quality, specifications, service and so on, so
that supplies exactly match their needs.
Technical – it may be cost-effective to invest in more advanced production machinery, IT and software
when operating on a larger scale.
Managerial – larger firms can afford to have specialist managers for different functions within a
business – such as Marketing, Finance and Human Resources. Furthermore, they may be able to pay the
higher salaries required to attract the best people, leading to better planning and decision making.
Specialisation – with a larger workforce, the firm may be better able to divide up the work and recruit
people whose skills very closely match the requirements of the job.
Marketing – more options are available for larger firms, such as television and other national media,
which would not be cost-effective for smaller producers. The marketing cost for selling 10 million items
might be no greater than to sell 1 million items. Larger firms might find it easier to gain publicity for
new launches simply because of their existing reputation.
Financial – there is a wider range of finance options available to larger firms, such as the stock market,
bonds and other kinds of bank lending. Furthermore, a larger firm is likely to be perceived by banks as
a lower risk and the cost of borrowing is likely to be lower.
Risk bearing – a larger firm can be safer from the risk of failure if it has a more diversified product
range. A larger firm may have greater resilience in the case of a downturn in its market because of
larger reserves and greater scope to make cutbacks.
Social and welfare – larger firms are more likely to be able to justify additional benefits for employees
such as pension funds, healthcare, sports and social facilities, which in turn can help attract and retain
good employees.

External economies of scale

External economies of scale arise from firms in related industries operating in a concentrated
geographical area; suppliers of services and raw materials to all these firms can do so more efficiently.
Infrastructure such as roads and sophisticated telecommunications are easier to justify.
There is also likely to be a growing local pool of skilled labour as other local firms in the industry also
train workers. This gives a larger and more flexible labour market in the area.

Diseconomies of scale
These are inefficiencies that can creep in when a firm operates on a larger scale (do not confuse with
high capacity utilisation). The main diseconomies of scale are:
Lack of motivation – in larger firms, workers can feel that they are not appreciated or valued as
individuals - see Mayo and Herzberg. It can be more difficult for managers in larger firms to develop
the right kind of relationship with workers. If motivation falls, productivity may fall leading to
inefficiencies.
Poor communication – it can be easier for smaller firms to communicate with all staff in a personal
way. In larger firms, there is likely to be greater use written of notes rather than by explaining
personally. Messages can remain unread or misunderstood and staff are not properly informed.
Co-ordination – a very large business takes a lot of organising, leading to an increase in meetings and
planning to ensure that all staff know what they are supposed to be doing. New layers of management
may be required, adding to costs and creating further links in the chain of communication.

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