Production and Cost

Anaslysis
Production and cost analysis are crucial for businesses to make
informed decisions about pricing, production, and resource
allocation. By understanding how changes in inputs affect outputs
and the costs associated with producing those outputs, businesses
can make adjustments to their strategies to maximize revenue.

PRODUCTION CONCEPT
In economics, a production function gives the technological relation between quantities of
physical inputs and quantities of output of goods. The production function is one of the key
concepts of mainstream neoclassical theories, used to define marginal product and to
distinguish allocative efficiency, a key focus of economics. One important purpose of the
production function is to address allocative efficiency in the use of factor inputs in production and
the resulting distribution of income to those factors, while abstracting away from the technological
problems of achieving technical efficiency, as an engineer or professional manager might
understand it.
For modelling the case of many outputs and many inputs, researchers often use the so-called
Shephard's distance functions or, alternatively, directional distance functions, which are
generalizations of the simple production function in economics.[1]
In macroeconomics, aggregate production functions are estimated to create a framework in
which to distinguish how much of economic growth to attribute to changes in factor allocation
(e.g. the accumulation of physical capital) and how much to attribute to advancing technology.
Some non-mainstream economists, however, reject the very concept of an aggregate production
function.[2][3]

The theory of production functions[edit]

In general, economic output is not a (mathematical) function of input, because any given set of
inputs can be used to produce a range of outputs. To satisfy the mathematical definition of
a function, a production function is customarily assumed to specify the maximum output
obtainable from a given set of inputs. The production function, therefore, describes a boundary or
frontier representing the limit of output obtainable from each feasible combination of input.
Alternatively, a production function can be defined as the specification of the minimum input
requirements needed to produce designated quantities of output. Assuming that maximum output
is obtained from given inputs allows economists to abstract away from technological and
managerial problems associated with realizing such a technical maximum, and to focus
exclusively on the problem of allocative efficiency, associated with the economic choice of how
much of a factor input to use, or the degree to which one factor may be substituted for another. In
the production function itself, the relationship of output to inputs is non-monetary; that is, a
production function relates physical inputs to physical outputs, and prices and costs are not
reflected in the function.
In the decision frame of a firm making economic choices regarding production—how much of
each factor input to use to produce how much output—and facing market prices for output and
inputs, the production function represents the possibilities afforded by an exogenous technology.
Under certain assumptions, the production function can be used to derive a marginal product for
each factor. The profit-maximizing firm in perfect competition (taking output and input prices as
given) will choose to add input right up to the point where the marginal cost of additional input
matches the marginal product in additional output. This implies an ideal division of the income
generated from output into an income due to each input factor of production, equal to the
marginal product of each input.
The inputs to the production function are commonly termed factors of production and may
represent primary factors, which are stocks. Classically, the primary factors of production were
land, labour and capital. Primary factors do not become part of the output product, nor are the
primary factors, themselves, transformed in the production process. The production function, as
a theoretical construct, may be abstracting away from the secondary factors and intermediate
products consumed in a production process. The production function is not a full model of the
production process: it deliberately abstracts from inherent aspects of physical production
processes that some would argue are essential, including error, entropy or waste, and the
consumption of energy or the co-production of pollution. Moreover, production functions do not
ordinarily model the business processes, either, ignoring the role of strategic and operational
business management. (For a primer on the fundamental elements of microeconomic production
theory, see production theory basics).
The production function is central to the marginalist focus of neoclassical economics, its
definition of efficiency as allocative efficiency, its analysis of how market prices can govern the
achievement of allocative efficiency in a decentralized economy, and an analysis of the
distribution of income, which attributes factor income to the marginal product of factor input.

Specifying the production function[edit]

A production function can be expressed in a functional form as the right side of

where is the quantity of output and are the quantities of factor inputs (such as

capital, labour, land or raw materials). For it must be since we cannot produce
anything without inputs.

If is a scalar, then this form does not encompass joint production, which is a production

process that has multiple co-products. On the other hand, if maps

from to then it is a joint production function expressing the determination

of different types of output based on the joint usage of the specified quantities of

the inputs.
One formulation is as a linear function:
where are parameters that are determined empirically. Linear functions imply that
inputs are perfect substitutes in production. Another is as a Cobb–Douglas production
function:

where is the so-called total factor productivity. The Leontief production

function applies to situations in which inputs must be used in fixed proportions;
starting from those proportions, if usage of one input is increased without another
being increased, the output will not change. This production function is given by

Other forms include the constant elasticity of substitution production function

(CES), which is a generalized form of the Cobb–Douglas function, and the
quadratic production function. The best form of the equation to use and the

values of the parameters ( ) vary from company to company and industry to

industry. In the short run, production function at least one of the 's (inputs)
is fixed. In the long run, all factor inputs are variable at the discretion of
management.
Moysan and Senouci (2016) provide an analytical formula for all 2-input,
neoclassical production functions.[4]

Production function as a graph[edit]

 Quadratic production
function
Any of these equations can be plotted on a graph. A typical (quadratic)
production function is shown in the following diagram under the assumption of a
single variable input (or fixed ratios of inputs so they can be treated as a single
variable). All points above the production function are unobtainable with current
technology, all points below are technically feasible, and all points on the
function show the maximum quantity of output obtainable at the specified level
of usage of the input. From point A to point C, the firm is experiencing positive
but decreasing marginal returns to the variable input. As additional units of the
input are employed, output increases but at a decreasing rate. Point B is the
point beyond which there are diminishing average returns, as shown by the
declining slope of the average physical product curve (APP) beyond point Y.
Point B is just tangent to the steepest ray from the origin hence the average
physical product is at a maximum. Beyond point B, mathematical necessity
requires that the marginal curve must be below the average curve
(See production theory basics for further explanation and Sickles and Zelenyuk
(2019) for more extensive discussions of various production functions, their
generalizations and estimations).

Stages of production[edit]
To simplify the interpretation of a production function, it is common to divide its range into 3
stages. In Stage 1 (from the origin to point B) the variable input is being used with increasing
output per unit, the latter reaching a maximum at point B (since the average physical product is
at its maximum at that point). Because the output per unit of the variable input is improving
throughout stage 1, a price-taking firm will always operate beyond this stage.
In Stage 2, output increases at a decreasing rate, and the average and marginal physical
product both decline. However, the average product of fixed inputs (not shown) is still rising,
because output is rising while fixed input usage is constant. In this stage, the employment of
additional variable inputs increases the output per unit of fixed input but decreases the output per
unit of the variable input. The optimum input/output combination for the price-taking firm will be in
stage 2, although a firm facing a downward-sloped demand curve might find it most profitable to
operate in Stage 2. In Stage 3, too much variable input is being used relative to the available
fixed inputs: variable inputs are over-utilized in the sense that their presence on the margin
obstructs the production process rather than enhancing it. The output per unit of both the fixed
and the variable input declines throughout this stage. At the boundary between stage 2 and
stage 3, the highest possible output is being obtained from the fixed input.

Law of variable proportion

Law of Variable Proportion is regarded as an important theory in
Economics. It is referred to as the law which states that when the
quantity of one factor of production is increased, while keeping all
other factors constant, it will result in the decline of the marginal
product of that factor.
The Law of Variable Proportions or Returns to a Factor plays an
important role in the study of the Theory of Production. In this
article, we will look at the meaning, explanation, stages, significance,
and reasons behind the operation of the Law of Variable
Proportions.

Law of Variable Proportions Explained

Let’s understand this law with the help of another example:

In this example, the land is the fixed factor and labour is the variable
factor. The table shows the different amounts of output when you
apply different units of labour to one acre of land which needs fixing.

The following diagram explains the law of variable proportions. In

order to make a simple presentation, we draw a Total Physical
Product (TPP) curve and a Marginal Physical Product (MPP) curve
as smooth curves against the variable input (labour).

Watch Videos on Law of Constant Proportion –

Three Stages of the Law

The law has three stages as explained below:

1. Stage I – The TPP increases at an increasing rate and the MPP

increases too. The MPP increases with an increase in the units of
the variable factor. Therefore, it is also called the stage of
increasing returns. In this example, the Stage I of the law runs up
to three units of labour (between the points O and L).
2. Stage II – The TPP continues to increase but at a diminishing rate.
However, the increase is positive. Further, the MPP decreases with
an increase in the number of units of the variable factor. Hence, it
 is called the stage of diminishing returns. In this example, Stage II
runs between four to six units of labour (between the points L and
M). This stage reaches a point where TPP is maximum (18 in the
above example) and MPP becomes zero (point R).
3. Stage III – Now, the TPP starts declining, MPP decreases and
becomes negative. Therefore, it is called the stage of negative
returns. In this example, Stage III runs between seven to eight units
of labour (from the point M onwards).
Learn more about Returns to Scale here in detail

Significance of the three stages

Stage I

A producer does not operate in Stage I. In this stage, the marginal

product increases with an increase in the variable factor.

Therefore, the producer can employ more units of the variable to

efficiently utilize the fixed factors. Hence, the producer would prefer
to not stop in Stage I but will try to expand further.

Stage III

Producers do not like to operate in Stage III either. In this stage, there
is a decline in total product and the marginal product becomes
negative.

In order to increase the output, producers reduce the amount of

variable factor. However, in Stage III, he incurs higher costs and also
gets lesser revenue thereby getting reduced profits.

Stage II
Any rational producer avoids the first as well as third stages of
production. Therefore, producers prefer Stage II – the stage of
diminishing returns. This stage is the most relevant stage of operation
for a producer according to the law of variable proportions.

Law of Variable Proportions in terms of TPP and

MPP
The explanation is as follows:

Law of Variable Proportions – in terms of TPP

We know that the law of variable proportions shows the relationship

between units of a variable factor and the total physical product.

Also, if we keep other factors constant and increase the units of the
variable factor, then the TPP initially increases at an increasing rate,
then at a diminishing rate, and finally declines. Therefore, it has three
clear stages:

1. I – TPP increasing at an increasing rate

2. II – TPP increasing at a diminishing rate
3. III – TPP declining
Example of Law of Variable Proportion in terms of TPP

Example of Law of Variable Proportion in terms of TPP

Diagram of Law of Variable Proportion in terms of TPP

Law of Variable Proportions in terms of MPP

The Law also states that if we keep all other factors constant and
increase the units of a variable factor, then the marginal physical
product initially increases, then decreases, and finally becomes
negative. Therefore, it has three stages:

1. I – MPP increasing
2. II – MPP decreasing but remaining positive
3. III – MPP continuing to decrease and becoming negative
Reason for the Operation of the Law
 In the short-term, we cannot vary all factors of production.
 In this case, there is only one variable factor while others are fixed.
 All other factors combine optimally to produce the maximum
output.
 Before the point of optimum combination, if the units of a variable
factor increase, then the factor proportion becomes more suitable
and it leads to more efficient utilization of the fixed factors.
Therefore, the marginal physical product increases.
 During the initial stages, the total product tends to rise at an
increasing rate when the producer employs more units of a variable
factor to the fixed factors.
 Subsequently, beyond the point of optimum combination, if the
producer employs more units of the variable factor, then the factor
proportion becomes inefficient. Therefore, the marginal product of
that variable factor declines.
 Also, the producer sees a fall in the quantity of the fixed factor
input per unit of the variable as he increases the units of the
variable factor.
 Therefore, successive units of the variable input add decreasing
amounts to the total output as they have less fixed inputs to work
with.
Law of Returns to Scale : Definition,
Explanation and Its Types
Article shared by:
Law of Returns to Scale : Definition, Explanation and Its
Types!

In the long run all factors of production are variable. No factor is

fixed. Accordingly, the scale of production can be changed by
changing the quantity of all factors of production.

Definition:
“The term returns to scale refers to the changes in output as all
factors change by the same proportion.”

Returns to scale are of the following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale

Explanation:

In the long run, output can be increased by increasing all factors

in the same proportion. Generally, laws of returns to scale refer
to an increase in output due to increase in all factors in the same
proportion. Such an increase is called returns to scale.

Suppose, initially production function is as follows:

P = f (L, K)

Now, if both the factors of production i.e., labour and capital are
increased in same proportion i.e., x, product function will be
rewritten as.
The above stated table explains the following three
stages of returns to scale:

1. Increasing Returns to Scale:

Increasing returns to scale or diminishing cost refers to a

situation when all factors of production are increased, output
increases at a higher rate. It means if all inputs are doubled,
output will also increase at the faster rate than double. Hence, it
is said to be increasing returns to scale. This increase is due to
many reasons like division external economies of scale.
Increasing returns to scale can be illustrated with the help of a
diagram 8.
In figure 8, OX axis represents increase in labour and capital
while OY axis shows increase in output. When labour and capital
increases from Q to Q 1, output also increases from P to P 1 which
is higher than the factors of production i.e. labour and capital.

2. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production

situation, where if all the factors of production are increased in a
given proportion, output increases in a smaller proportion. It
means, if inputs are doubled, output will be less than doubled. If
20 percent increase in labour and capital is followed by 10
percent increase in output, then it is an instance of diminishing
returns to scale.

The main cause of the operation of diminishing returns to scale is

that internal and external economies are less than internal and
external It is clear from diagram 9.
In this diagram 9, diminishing returns to scale has been shown.
On O

diseconomies. It is clear from diagram 9.

axis, labour and capital are given while on OY axis, output. When
factors of production increase from Q to Q1 (more quantity) but
as a result increase in output, i.e. P to P 1 is less. We see that
increase in factors of production is more and increase in
production is comparatively less, thus diminishing returns to
scale apply.

3. Constant Returns to Scale:

Constant returns to scale or constant cost refers to the production

situation in which output increases exactly in the same
proportion in which factors of production are increased. In
simple terms, if factors of production are doubled output will also
be doubled.
In this case internal and external economies are exactly equal to
internal and external diseconomies. This situation arises when
after reaching a certain level of production, economies of scale
are balanced by diseconomies of scale. This is known as
homogeneous production

This is known as homogeneous production function. Cobb-

Douglas linear homogenous production function is a good
example of this kind. This is shown in diagram 10. In figure 10,
we see that increase in factors of production i.e. labour and
capital are equal to the proportion of output increase. Therefore,
the result is constant returns to scale.
VARIOUS COST CONCEPT AND CLASSIFICATION
Concept of Cost:
According to the Chartered Institute of Management Accountants,
cost is “the amount of expenditure (actual or notional)
incurred on or attributable to a specified thing or
activity.” Similarly, according to Anthony and Wilsch “cost is a
measurement in monetary terms of the amount of
resources used for some purposes.”
Cost has been defined by the Committee on Cost Terminology of the
American Accounting Association as “the foregoing, in monetary
terms, incurred or potentially to be incurred in the realisation of the
objective of management which may be manufacturing of a product
or rendering of a service.”

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From the above, it may be stated that cost means the total of all
expenses incurred for a product or a service. Thus, cost of an article
means the actual outgoings or ascertained changes incurred in its
production and sale activities. In short, it is the amount of resources
used up in exchange for some goods or services.

The so-called resources are expressed in terms of money or

monetary units. What we stated above will not be a meaningful one
until the same is used with an adjective only, i.e. when it
communicates the meaning for which it is intended.

Thus, when we say Prime Cost or Works Cost or Fixed Cost etc., we
want to explain a particular meaning which is essential while
computing, measuring or analysing the various aspects of cost.

Classification of Cost:
Classification of costs implies the process of grouping costs
according to their common characteristics. A proper classification of
costs is absolutely necessary to mention the costs with cost centres.
Usually, costs are classified according to their nature, viz., material,
labour, over-head, among others. An identical cost figure may be
classified in various ways according to the needs of the firms.

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The above classification may be outlined as:

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However, the classification of cost may be depicted as

given:
(a) According to Elements:
Under the circumstances, costs are classified into three broad
categories Material, Labour and Overhead. Now, further
subdivision may also be made for each of them. For example,
Material may be subdivided into raw materials, packing materials,
consumable stores etc. This classification is very useful in order to
ascertain the total cost and its components. Same classification may
also be made for labour and overhead.
(b) According to Functions:
The total costs are divided into different segments according to the
purpose of the firm. That is why costs are grouped as per the
requirements of the firm in order to evaluate its functions properly.
In short, the total costs include all costs starting from cost of
materials to the cost of packing the product.

It takes the cost of direct material, direct labour and chargeable

expenses and all indirect

expenses under the head Manufacturing/Production cost.

At the same time, administration cost (i.e. relating to office and

administration) and Selling and Distribution expenses (i.e. relating
to sales) are to be classified separately and to be added in order to
find out the total cost of the product. If these functional
classifications are not made properly, true cost of the product
cannot accurately be ascertained.

(c) According to Variability:

Practically, costs are classified according to their behaviour relating
to the change (increase or decrease) in their volume of activity.

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These costs as per volume may be subdivided into:

(i) Fixed Cost;

(ii) Variable Cost;

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(iii) Semi-variable Cost.

Fixed Costs are those which do not vary with the change in output,
i.e., irrespective of the quantity of output produced, it remains fixed
(e.g., Salaries, Rent etc.) up to a certain limit. It is interesting to
note that if more units are product, fixed cost per unit will be
reduced, and, if less units are produced, obviously, fixed cost per
unit will be increased.

Variable Costs, on the other hand, are those which vary

proportionately with the volume of output. So the cost per unit will
remain fixed irrespective of the quantity produced. That is, there is
no direct effect on the cost per unit if there is a change in the
volume of output (e.g. price of raw material, labour etc.,).

On the contrary, semi-variable costs are those which are partly fixed
and partly variable (e.g. Repairs of building).

(d) According to Controllability:

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Costs may, again, be subdivided into two broad categories according

to the performance done by any member of the firm.

They are:
(i) Controllable Costs; and

(ii) Uncontrollable Costs.

Controllable Costs are those costs which may be influenced by the

decision taken by a specified member of the administration of the
firm or, it may be stated, that the costs which at least partly depend
on the management and is controllable by them, e.g. all direct costs,
direct material, direct labour and chargeable expenses (components
of Prime Cost) are controllable by lower management level and is
done accordingly.

Uncontrollable Costs are those which are not influenced by the

actions taken by any specific member of the management. For
example, fixed costs, viz., rent of building, payment for salaries etc.

(e) According to Normality:

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Under this condition, costs are classified according to the normal

needs for a given level of output for a normal level of activity
produced for such output.

They are divided into:

(i) Normal Costs; and

(ii) Abnormal Costs.

Normal Costs are those costs which are normally required for a
normal production at a given level of output and which is a part of
production.

Abnormal Costs, on the other hand, are those costs which are not
normally required for a given level of output to be produced
normally, or which is not a part of cost of production.

(f) According to Time:

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Costs may also be classified according to the time element

in it. Accordingly, costs are classified into:
(i) Historical Costs; and
(ii) Predetermined Costs.

Historical Costs are those costs which are taken into consideration
after they have been incurred. This is possible particularly when the
production of a particular unit of output has already been made.
They have only historical value and cannot assist in controlling
costs.

Predetermined Costs, on the other hand, are the estimated costs.

Such costs are computed in advanced on the basis of past
experience and records. Needless to say here that it becomes
standard cost if it is determined on scientific basis. When such
standard costs are compared with the actual costs, the reasons of
variance will come out which will help the management to take
proper steps for reconciliation.

(g) According to Traceability:

Costs can be identified with a particular product, process,
department etc. They are divided into:
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(i) Direct (Traceable) Costs; and

(ii) Indirect (Non-Traceable) Costs.

Direct/Traceable Costs are those costs which can directly be traced

or allocated to a product, i.e. it includes all traceable costs, viz., all
expenses relating to cost of raw materials, labour and other service
utilised which can be traced easily.

Indirect/Non-Traceable Costs are those costs which cannot directly

be traced or allocated to a product, i.e. it includes all non-traceable
costs, e.g. salary of store-keepers, general administrative expenses,
i.e. which cannot properly be allocated directly to a product.

(h) According to Planning and Control:

Costs may also be classified into:
(i) Budgeted Costs; and

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(ii) Standard Costs.

Budgeted Costs refer to the expected cost of manufacture computed

on the basis of information available in advance of actual
production or purchase. Practically, budgeted costs include
standard costs, both are predetermined costs and their amount may
coincide but their objectives are different.

Standard Costs, on the other hand, is a predetermination of what

actual costs should be under projected conditions serving as a basis
of cost control and, as a measure of product efficiency, when
ultimately aligned actual cost. It supplies a medium by which the
effectiveness of current results can be measured and the
responsibility for derivations can be placed.

Standard Costs are predetermined for each element, viz., material,

labour and overhead.

Standard Costs include:

(i) The cost per unit is determined to make an estimated
total output for the future period for:
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(a) Material;

(b) Labour; and

(c) Overhead.

(ii) The cost must depend on the past experience and experiments
and specification of the technical staff.

(iii) The cost must be expressed in terms of rupees.

(i) According to Management Decisions: Under this, costs

may also be classified as:
(a) Marginal Cost:
Marginal Cost is the cost for producing additional unit or units by
segregation of fixed costs (i.e., cost of capacity) from variable cost
(i.e. cost of production) which helps to know the profitability.
Moreover, we know, in order to increase the production, certain
expenses (fixed) may not increase at all, only some expenses
relating to materials, labour and variable expenses are increased.
Thus, the total cost so increased by the production of one unit or
more is the cost of marginal unit and the cost is known as marginal
cost or incremental cost.

(b) Differential Cost:

Differential Cost is that portion of the cost of a function attributable
to and identifiable with an added feature, i.e. the change in costs as
a result of change in the level of activity or method of production.

(c) Opportunity Cost:

It is the prospective change in cost following the adoption of an
alternative machine, process, raw materials, specification or
operation. In other words, it is the maximum possible alternative
earnings which might have been earned if the existing capacity had
been changed to some other alternative way.

(d) Replacement Cost:

It is the cost, at current prices, in a particular locality or market
area, of replacing an item of property or a group of assets.

(e) Implied Cost:

It is the cost used to indicate the presence of arbitrary or subjective
elements of product cost having more than usual significance. It is
also called notional cost, e.g., interest on capital —although no
interest is paid. This is particularly useful while decisions are taken
regarding alternative capital investment projects.

(f) Sunk Cost:

It is the past cost arising out of a decision which cannot be revised
now, and associated with specialised equipment’s or other facilities
not readily adaptable to present or future purposes. Such cost is
often regarded as constituting a minor factor in decisions affecting
the future.

Cost-Output Relationship
A proper understanding of the nature and behavior of costs is a must for regulation
and control of cost of production. The cost of production depends on money forces
and an understanding of the functional relationship of cost to various forces will help
us to take various decisions. Output is an important factor, which influences the cost.
 The cost-output relationship plays an important role in determining the optimum
level of production. Knowledge of the cost-output relation helps the manager in cost
control, profit prediction, pricing, promotion etc. The relation between cost and its
determinants is technically described as the cost function.

C= f (S, O, P, T ….)

Where;

 C= Cost (Unit or total cost)

 S= Size of plant/scale of production
 O= Output level
 P= Prices of inputs
 T= Technology

Considering the period the cost function can be classified as (1) short-run cost function
and (2) long-run cost function. In economics theory, the short-run is defined as that
period during which the physical capacity of the firm is fixed and the output can be
increased only by using the existing capacity allows to bring changes in output by
physical capacity of the firm.

1. Cost-Output Relationship in the

Short-Run
The cost concepts made use of in the cost behavior are Total cost, Average cost,
and Marginal cost.

Total cost is the actual money spent to produce a particular quantity of output. Total
Cost is the summation of Fixed Costs and Variable Costs.

TC=TFC+TVC

Up to a certain level of production Total Fixed Cost i.e., the cost of plant, building,
equipment etc, remains fixed. But the Total Variable Cost i.e., the cost of labor, raw
materials etc., vary with the variation in output. Average cost is the total cost per unit.
It can be found out as follows.

AC=TC/Q
The total of Average Fixed Cost (TFC/Q) keep coming down as the production is
increased and Average Variable Cost (TVC/Q) will remain constant at any level of
output.

Marginal Cost is the addition to the total cost due to the production of an additional
unit of product. It can be arrived at by dividing the change in total cost by the change
in total In the short-run there will not be any change in Total Fixed C0st. Hence change in
total cost implies change in Total Variable Cost only.

Units Total Total Total Average Average Average Marginal

of fixed variable cost variable fixed cost cost MC
Output cost cost (TFC cost cost (TC/Q)
Q TFC TVC + (TVC / (TFC / AC
TVC) Q) Q) AFC
TC AVC

0 – – 60 – – – –

1 60 20 80 20 60 80 20

2 60 36 96 18 30 48 16

3 60 48 108 16 20 36 12

4 60 64 124 16 15 31 16

5 60 90 150 18 12 30 26

6 60 132 192 22 10 32 42

The above table represents the cost-output relationship. The table is prepared on the basis of
the law of diminishing marginal returns. The fixed cost Rs. 60 May include rent of factory
building, interest on capital, salaries of permanently employed staff, insurance etc. The table
shows that fixed cost is same at all levels of output but the average fixed cost, i.e., the fixed
cost per unit, falls continuously as the output increases. The expenditure on the variable factors
(TVC) is at different rate. If more and more units are produced with a given physical capacity
the AVC will fall initially, as per the table declining up to 3rd unit, and being constant up to
4th unit and then rising. It implies that variable factors produce more efficiently near a firm’s
optimum capacity than at any other levels of output and later rises. But the rise in AC is felt
only after the start rising. In the table ‘AVC’ starts rising from the 5th unit onwards whereas the
‘AC’ starts rising from the 6th unit only so long as ‘AVC’ declines ‘AC’ also will decline.
‘AFC’ continues to fall with an increase in Output. When the rise in ‘AVC’ is more than the
decline in ‘AFC’, the total cost again begin to rise. Thus there will be a stage where the ‘AVC’,
the total cost again begin to rise thus there will be a stage where the ‘AVC’ may have started
rising, yet the ‘AC’ is still declining because the rise in ‘AVC’ is less than the droop in ‘AFC’.

Thus the table shows an increasing returns or diminishing cost in the first stage and diminishing
returns or diminishing cost in the second stage and followed by diminishing returns or
increasing cost in the third stage.

The short-run cost-output relationship can be shown graphically as follows.

In the above graph the “AFC’ curve continues to fall as output rises an account of its spread
over more and more units Output. But AVC curve (i.e. variable cost per unit) first falls and
than rises due to the operation of the law of variable proportions. The behavior of “ATC’ curve
depends upon the behavior of ‘AVC’ curve and ‘AFC’ curve. In the initial stage of production
both ‘AVC’ and ‘AFC’ decline and hence ‘ATC’ also decline. But after a certain point ‘AVC’
starts rising. If the rise in variable cost is less than the decline in fixed cost, ATC will still
continue to decline otherwise AC begins to rise. Thus the lower end of ‘ATC’ curve thus turns
up and gives it a U-shape. That is why ‘ATC’ curve are U-shaped. The lowest point in ‘ATC’
curve indicates the least-cost combination of inputs. Where the total average cost is the
minimum and where the “MC’ curve intersects ‘AC’ curve, It is not be the maximum output
level rather it is the point where per unit cost of production will be at its lowest.
 The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows:

1.
1. If both ‘AFC’ and ‘AVC’ fall, ‘ATC’ will also fall.
2. When ‘AFC’ falls and ‘AVC’ rises
3. ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
4. ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
5. ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’

2. Cost-output Relationship in the Long-

Run
Long run is a period, during which all inputs are variable including the one, which are fixes in
the short-run. In the long run a firm can change its output according to its demand. Over a 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.

The long-run cost-output relations therefore imply the relationship between the total cost and
the total output. In the long-run cost-output relationship is influenced by the law of returns to
scale.

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.

The long-run cost-output relationship is shown graphically with the help of “LCA’ curve.
To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves. In the above figure
it is assumed that technologically there are only three sizes of plants — small, medium and
large, ‘SAC’, for the small size, ‘SAC2’ for the medium size plant and ‘SAC3’ for the large
size plant. If the firm wants to produce ‘OP’ units of output, it will choose the smallest plant.
For an output beyond ‘OQ’ the firm wills optimum for medium size plant. It does not mean
that the OQ production is not possible with small plant. Rather it implies that cost of production
will be more with small plant compared to the medium plant.

For an output ‘OR’ the firm will choose the largest plant as the cost of production will be more
with medium plant. Thus the firm has a series of ‘SAC’ curves. The ‘LCA’ curve drawn will
be tangential to the entire family of ‘SAC’ curves i.e. the ‘LAC’ curve touches each ‘SAC’
curve at one point, and thus it is known as envelope curve. It is also known as planning curve
as it serves as guide to the entrepreneur in his planning to expand the production in future. With
the help of ‘LAC’ the firm determines the size of plant which yields the lowest average cost of
producing a given volume of output it anticipates.

Economies & Diseconomies of Scale:

Overview & Examples
The existence of economies of scale vs. diseconomies of scale is determined based on the
relationship between the production and price of an item or product. Economies of Scale is
the concept referring to a business event where the price of an item or product decreases as
the production of the same item or product increases. Diseconomies of scale defined is the
inverse of economies of scale. It is where prices of an item or product increase as output of
the same item or product decreases. Both concepts are commonly used in the business world
to describe the status of production of an item or product. These concepts can also be used to
conduct research into reasons why efficiency is being maximized in certain areas of a
business or why efficiency is lacking in other areas of a business.
Economies and Diseconomies of Scale Graph
On a diseconomies of scale graph, the cost of a given item or product is shown to increase
as each new unit of the product is created. The y-axis in this type of graph represents the
average cost for the given product, and the x-axis represents output or production of the given
product.

This graph shows the diseconomies of scale occurrence where AC = Average cost
(Total cost ÷ Quantity) O = Output LRAC = Long run average cost C1, C2 =
Cost

On an economies of scale graph, the cost of the product will be shown to decrease as the
output of the product increases. The y- and x-axes represent the same variables as they do on
a diseconomies of scale graph.
The average cost (left hand side y-axis) is decreasing as the quantity produced
increases (output, bottom x-axis)

On the diseconomies of scale graph, the direction of the line trends both upwards and to the
right. On an economies of sale graph, the direction of the line trends both downwards and to
the right.

Economies of Scale Definition

Economies of scale is the concept suggesting that a business receives an advantage in cost
per product produced as its output of the product increases. This occurs because the per-item
production costs decreases overall in relation to the total amount of products being created.
This can happen for a number of reasons:

 Businesses buy in bulk for needed supplies

 Efficient production
 Cutting wasteful spending
 Reduced marketing campaigns
 Risk is diversified
 Capital goods and investments are cheaper
 Transportation and storage is cheaper

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Cause of Diseconomies of Scale
Diseconomies of scale can occur in businesses for many reasons, but they mostly occur when
a business plans to grow or expand in some way. There are four main areas that businesses
should monitor closely when deciding to scale their business:

Internal and External Economies

When a firm opts for large-scale production, the economies arising
out of it are grouped into two categories:

1. Internal economies – economies of production that the firm

accrues when it increases the output leading to a drop in the cost of
production. These arise due to endogenous factors like
entrepreneurial efficiency, talents of the management team, type of
machinery, etc. These economies arise within the firm and help the
firm only.
2. External economies – these are the benefits that each member firm
of the industry accrues due to the expansion of the entire industry.
Browse more Topics under Theory Of Cost

 Cost Concepts
 Short Run Average Costs
 Short Run Total Costs
 Long Run Average Cost Curve
Internal Diseconomies and Economies of Scale

While studying returns to scale, we observed that they increase

during the initial stages, remain constant for a while, and then start
decreasing. The reason is simple – initially, the firm enjoys internal
economies of scale and after a certain limit, it suffers from internal
diseconomies of scale. Let’s look at the types of economies and
diseconomies:

Technical

Large-scale production is linked to technical economies. When a firm

increases its scale of operations, it needs to use a more specialized
and efficient form of capital equipment and machinery. Such
machinery helps to produce larger outputs at a lower unit cost.

Further, as the scale of production increases and the amount of labor

and other factors becomes larger, the firm manages to reduce costs by
introducing a degree of division of labor and specialization.

However, beyond a certain point, the firm experiences diseconomies

of scale. This happens because after reaching a large enough output,
the firm utilizes almost all possibilities of the division of labor
and employment of efficient machinery.

Post this, any increase in the size of the plant causes the costs to rise.
When the scale of operations becomes too large, the management
finds it more difficult to control and coordinate the operations.
Managerial

As the output increases, the firm can apply the division of labor to the
management as well. For example, the production manager can look
after production, the sales manager can look after sales, etc. When the
scale of production increases further, the firm divides each
department into sub-departments like sales is divided into
advertising, exports, and service.

Thus helps in increasing the efficiency and productivity of the

management team since a specialist manages each sub-department.
Further, the firm has the option to decentralize decision-making
authority enhancing the efficiency further. Therefore, specialized
management allows the firm to reduce managerial costs.

However, as the firm increases its scale of operations beyond a

certain limit, the management finds it difficult to control and
coordinate between departments. This leads to managerial
diseconomies.

Commercial

As a firm increases its volume of production, it requires large

amounts of raw material and components. Hence, it places a bulk
order for such material and components and enjoys
discounted pricing for them.

Economies are also achieved during sales. If the sales staff is working
under-capacity, then the firm can sell additional output at little extra
cost.

Further, as the scale of production increases, the advertising cost per

unit fall. Hence, the firm benefits from economies
of advertising too. After an optimum level, these economies start
becoming diseconomies though.

Financial
When a firm wants to raise finance, a large-scale firm has many
benefits like:

 Better security to bankers

 Well-known
 Can raise finance at lower costs, etc.
However, after the optimum scale of production, the financial costs
rise faster due to the increased dependence on external finances.

Risk-bearing

A firm enjoys the economies of risk-bearing if it has a large-scale

operation with diverse and multi-production capabilities. However, if
the diversification increases the economic disturbances rather than
covering them, then the risk increases.

Learn more about Sources of Internal Economies of Scale here.

External Diseconomies and Economies of Scale

External diseconomies and economies of scale are very important to

a firm. These are a result of the expansion of output of the entire
industry and not limited to an individual firm. They are available to
one or more firms in the following forms:

Cheaper Raw materials and Capital Equipment

At times, the expansion of an industry results in new and cheaper
sources of raw material, machinery, and other capital equipment. It
also results in an increased demand for the various types of materials
and equipment required by the industry.

Hence, such materials/equipment can be purchased from other

industries on a large scale. This, eventually, leads to a lower cost of
production and lower price. Therefore, firms using these
materials/equipment get them at lower prices.

Technological External Economies

Usually, when an entire industry expands, new technical knowledge

is discovered leading to new and improved machinery for the said
industry. This changes the technological coefficient of production
and enhances the productivity of the firms in the industry. Hence, the
cost of production reduces.

Development of Skilled Labor

As the industry expands, the labor gets accustomed to managing

various production processes and learns from the experience. This
increases the number of skilled workers which in turn has a favorable
effect on the levels of productivity.

Growth of Ancillary Industries

When a certain industry expands, many ancillary industries start

specializing in the production of raw materials, tools, machinery, etc.
These ancillary industries offer the materials/machinery at a low
price.

Similarly, some ancillary industries also start processing industrial

waste and create a useful product out of it. Overall, it leads to a lower
cost of production.

Better Transportation and Marketing Facilities

An expanding industry, usually, results in better transportation and
marketing networks. These aspects help reduce the cost of production
in the firms from the industry.

It is important to note that, certain disadvantages can neutralize the

advantages of the expansion of industry and cease the external
economies of scale. These are external diseconomies. When an
industry expands, the demand for certain materials and skilled labor
increases.

If these factors are in short supply, then their prices can increase.
Further, the geographical concentration of firms from the industry
can lead to higher transportation costs, marketing costs, pollution
control costs, etc.