Financial and Management

Accounting

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 Objectives

The objectives of this lecture are to:

• explain production and production function

• discuss production function with one variable input
• explain production function with two variable inputs
• describe returns to scale
• discuss economies of scale
• explain economies of scope

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 Lecture
Outline

• Introduction
• Production and Production Function
• Production Function with One Variable Input
• Production Function with Two Variable Inputs
• Returns to Scale
• Economies of Scale
• Economies of Scope
• Summary
• Check Your Learning
• Activity

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 Introductio
n

• The production process involves a series of steps to

convert some raw materials and/or other inputs into a good
or service.

• A business firm is an economic unit. It is also a production

unit.

• Production is one of the most important activities of a firm

in the circle of economic activity.

• The main objective of production is to satisfy the demand

for different kinds of goods and services of the community.

• Based on this, it is possible to take corrective and

preventive action Srilatha.K
as well as employ the data for planning,
 Production and
Production
Function

• The term “production” means transformation of physical

“inputs” into physical “outputs”.
• There are four general factors in production like land,
labour, capital and organisation.
• Always, the results after production will be either creation
of new utilities or addition of values.
• It is to be noted that higher levels of production is an
index of progress and growth of an organisation and that of
a society.

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 TRANAFORMATIO
INPUT OUTPUT
N PROCESS

EXIT TO
ENTRY FIRMS
INTO FIRMS

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• A “production function” expresses the technological or
engineering relationship between physical quantity of inputs
employed and physical quantity of outputs obtained by a
firm.

• It specifies a flow of output resulting from a flow of inputs

during a specified period of time.

• Factor inputs are of two types:

• Fixed inputs
• Variable inputs

• There are two types of production functions:

• Short run production function
• Long run production function
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• Important uses of Production Function:

It can be used to calculate or work out the least cost

input combination for a given output or the
maximum output-input combination for a given
cost.

It is useful in working out an optimal and economic

combination of inputs for getting a certain level of
output.

Production function also helps in making long run

decisions. If returns to scale are increasing, it is
wise to employ more factor units and increase
production.

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 Production
Function with One
Variable Input
• The law of variable proportions is one of the most
fundamental laws of production.

• It gives us some key insights in determination of the ideal

combination of factor inputs.

• The law can be stated as follows: “As the quantity of only

one factor input is increased to a given quantity of fixed
factors, beyond a particular point, the marginal, average and
total output eventually decline”.

• Certain terminologies include:

 Total product or output (TP): It is the output derived from
all units of factors, both, fixed & variable, employed by the
producer. It is also the sum of marginal output.

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o Average product or output (AP):
It can be obtained by dividing total output by the number of
variable factors employed.

o Marginal product or output (MP): It is the output

derived from the employment of an additional unit of a
variable factor.

• Trends in output is best defined through this

diagrammatic representation:

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 •The total output increases at an
increasing rate •When the producer
Stage 1 – Law of
increases the quantity of the variable
Increasing
factor, output increases due to the
Returns
complete utilisation of the “indivisible
factors”.

•In this stage, the TP increases at a

Stage 2 – Law of diminishing rate as both AP & MP are
Diminishing declining but they are positive.
Returns •It is only in this stage, the firm is
maximizing its total output.

•In this case, as the quantity of

variable input is increased to a given
quantity of fixed factors, output
Stage 3 – Law of becomes negative.
Negative Returns •During this stage, TP starts
diminishing, AP continues to diminish
and MP becomes negative
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 Production Function
with Two Variable
Inputs

• Isoproduct curve is a technique developed in recent

years to show the equilibrium of a producer with two
variable factor inputs.

• The term “isoquant” has been derived from ‘Iso’

meaning equal and ‘Quant’ meaning quantity.

• Isoquant is also called equal product curve or product

indifference curve or constant product curve.

• An isoproduct curve represents all the possible

combinations of two factor inputs which are capable of
producing the same level of output.
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• A catalogue of different combinations of inputs with
different levels of output can be indicated in a graph which is
called equal product map or isoquant map

• A number of isoquants representing different amount of

output are known as isoquant map.

• Marginal rate of technical substitution (MRTS) may be

defined as the rate at which a factor of production can be
substituted for another at the margin without affecting any
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change in the quantity of output
Combination Factor X Factor Y MRTS of X
s for Y
A 12 1 NIL
B 8 2 4:1
C 5 3 3:1
D 3 4 2:1
E 2 5 1:1
• Isocost line or curve is a parallel concept to the budget or
price line of the consumer.

• It shows two things: A

(a) prices of two inputs 30 units of factor x
3000/-
(b) total outlay of the firm.

B Srilatha.K
• Producer’s equilibrium is also known as Optimum
factor combination or least cost combination.

• The optimal combination of factor inputs may help in

either minimizing cost for a given level of output or
maximizing output with a given amount of investment
expenditure (outlay).

• Maximum output with minimum cost is possible only

when the position of equilibrium is reached.

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 Returns to
Scale

• In Returns to Scale, we study the change in output when all

factor inputs are changed or made available in required
quantity.

• In returns to scale, all the necessary factor inputs are

increased or decreased to the same extent so that whatever
the scale of production, the proportion among the factors
remains the same.

• Three phases of Returns to Scale are:

o Increasing returns to scale
o Constant returns to scale
o Diminishing returns to scale

• It may be noted that when the quantity of inputs are

increased in the same proportion, the scale of output or
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returns to scale may be either more than equal, equal or less
Increasing Returns to Scale
•When the producer is increasing the quantity of all factors
[scale] in a given proportion leading to a more than
proportionate increase in output.

•Any line passing through the origin will indicate the path
of expansion or increase in scale with definite proportion
between the two factors.

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Constant Returns to Scale
•Constant returns to scale is operating when all factor inputs
[scale] are increased in a given proportion leading to an
equiproportional increase in output.

•Economists also describe constant returns to scale as the

linear homogeneous production function.

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Diminishing Returns to Scale
•Diminishing returns to scale is operating when output
increases less than proportionately when compared to the
quantity of inputs used in the production process.

•It is clear that the distance between each successive

isoquant curve is progressively increasing along the scale
line OP

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 Economies of
Scale

Internal Economies:

Economies
Technical Overhead
of vertical
Economies Economies
Integration

Managerial Transport Risk

or and Bearing or
Commercial Storage Survival
Economies Economies Economies

Financial Labour
Economies Economies

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External economies:

Economies of
concentration Economies of Economies of
or information disintegration
agglomeration

Economies of
Economies of Economies of
government
physical factor welfare
action

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 Economies of
Scope

• Economies of scope may be defined as those benefits which

arise to a firm when it produces more than one product jointly
rather than producing two items separately by two different
business units.

• In this case, the benefits of the joint output of a single firm

are greater than the benefits if two products are produced
separately by two different firms.

• Economies-of-scope results in saving production costs. It

can be measured with the help of the following equation:

C Q1 +C Q2 -C Q1,Q2
SC =
C Q1,Q2
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 Summary
The following Points summarises the concepts of this unit.

• The main objective of production is to satisfy the demand for

different kinds of goods and services of the community.

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

into physical “outputs”.

• A “production function” expresses the technological or

engineering relationship between physical quantity of inputs
employed and physical quantity of outputs obtained by a firm.

• Law of variable proportions gives us some key insights in

determination of the ideal combination of factor inputs.

• Isoquant is also called equal product curve or product

indifference curve or constant product curve.

• Producer’s equilibrium is also known as Optimum factor

combination or least cost combination.
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 Check Your
Learning

1. Mention the stages of law of variable proportions?

Ans: The stages of law of variable proportions are:
• Stage of increasing returns
• Stage of diminishing returns
• Stage of negative returns

2. What are the external economies of scale?

Ans: The external economies of scale are:
• Economies of concentration or agglomeration
• Economies of information
• Economies of disintegration
• Economies of government action
• Economies of physical factors
• Economies of welfare

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 Activity

Activity 1

Computer learning centers have been opened in the

locality to cater to the growing demand of computer
courses and jobs in the market. However, from opening of
4 centers, the number of centers have now increased to 8.
Considering the internal and external diseconomies of
scale, list the various practical diseconomies that this could
bring to the operation in general.

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