PRODUCTION

 PRODUCTION FUNCTION
 LAW OF VARIABLE PROPORTION
 RETURNS TO SCALE
 ECONOMIES OF SCALE
 PRODUCERS’ SURPLUS
 Production
Production is the process of making or manufacturing goods and products
from raw materials or components. In other words, production takes inputs
and uses them to create an output which is fit for consumption – a good or
product which has value to an end-user or customer.
The production decision of a firm into three steps :
 Production Technology.
 Cost constraints.
 Input Choices.
THEORY OF THE FIRM :
It gives the explanation of how a firm makes cost-minimizing
production decisions and how its cost varies with its output.
 PRODUCTION FUNCTION
The production function gives the technological relation between quantities of
physical inputs and quantities of output of goods. Or in other words
The production function is a mathematical function stating the relationship between the
inputs and the outputs of the goods in production by a firm.

•Entrepreneurship, labor, land, and capital are major factors of input that can determine the
maximum output for a certain price.
•Analysts or producers can represent it by a graph and use the formula to find it.

Q = f(K, L) or Q = K+L

There are two types of productivity function, namely long run, and short run, depending on
the nature of the input variable.The short run is a period of time in which the quantity of at
least one input is fixed and the quantities of the other inputs can be varied. The long run is a
period of time in which the quantities of all inputs can be varied.
Short Run analysis: Effect on quantity produced by a change in a single variable of
production ( Assuming all other variables are constant)

Total Product
It refers to the total amount of output that a firm produces within a given period, utilizing available
inputs.

For a variable X( Eg: Unit of Labor) the

Average Product
It is output per unit of variable factor input.
Average Product (AP)= Total Product (TP)/ Total unit of Variable X

Marginal Product
Change in output from a unit change in variable (X)
Marginal product= Changed output/ changed input. : Q/ X
Law of Variable Proportions or Returns to a Factor
The law exhibits the relationship between the units of a variable factor and the amount
of output in the short-term. This is assuming that all other factors are constant. This
relationship is also called returns to a variable factor. The law states that keeping other factors
constant, when you increase the variable factor, then the total product initially increases at an
increases rate, then increases at a diminishing rate, and eventually starts declining.

ASSUMPTIONS;
1)One factor is variable while others remain
constant.
2)The variable factors have homogeneous units.
3)The technology remains same.
4)The proportion of various inputs in the mix may
be changed.
5)The law is applicable only in the short run, as all
factors are variable in nature in long run.
6)Physical units such as ton, kilo are used for
measuring the products. Monetary value is ignored.
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).
The efficient region of production is over that range of employment of variable input where the
marginal product of the variable input is declining but positive. This stage of production
is called rational or economic stage of production.

Law of Returns to Scale

Returns to scale refer to the change in output that results from a change in the factor inputs
simultaneously in the same proportion in the long run. Simply put, when a firm changes the
quantity of all inputs in the long run, it changes the scale of production for the goods.
According to Watson, “Returns to Scale is related to the behaviour of total output as all
inputs are varied in same proportion and it is a long run concept.”
According to Prof. Roger Miller, “Returns to scale refers to the relationship between
changes in output and proportionate changes in all factors of production”.
Three phases of returns to scale
(1) the law of increasing returns (2) the law of constant returns and (3) the law of
decreasing returns. Depending on whether the proportionate change in output equals,
exceeds, or falls short of the proportionate change in both the inputs, a production function
is classified as showing constant, increasing, or decreasing returns to scale.
ASSUMPTIONS OF RETURNS TO SCALE

 Homogeneous Production: This assumption assumes that the inputs used in production are
homogeneous, meaning that there is no differentiation between individual units of input. For example,
if labor is one of the inputs, this assumption implies that all units of labor are the same in terms of
productivity and skill
 Proportional Changes: The assumption of proportional changes states that when all inputs are
increased by a certain percentage, the output will increase by the same percentage. Similarly, if inputs
are decreased, output will also decrease by a proportional percentage. This assumption simplifies the
analysis of returns to scale by assuming a consistent relationship between input and output changes.
 Constant Technology: This assumption assumes that the technology used in production remains
constant as the scale of production changes. In other words, there are no technological advancements
or changes in production methods as the level of output varies. This assumption allows for a clearer
focus on the impact of scale alone on output changes.
It's important to note that these assumptions help in creating theoretical frameworks and
models to understand the concept of returns to scale. In the real world, there might be variations and
complexities that challenge these assumptions, but they provide a foundation for studying how changes
in input quantities affect the resulting output at different scales of production.
Increasing Returns to Scale:
If the proportional change in the output of
an organization is greater than the
proportional change in inputs, the
production is said to reflect increasing
returns to scale. For example, to produce a
particular product, if the quantity of inputs
is doubled and the increase in output is
more than double, it is said to be an
increasing returns to scale. When there is an
increase in the scale of production, the
average cost per unit produced is lower.
This is because at this stage an organization
enjoys high economies of scale.

RS = Returns to scale curve

RP = Segment; increasing returns to scale
PQ = segment; constant returns to scale
QS = segment; decreasing returns to scale
Constant Returns to Scale:
The production is said to generate constant returns to scale when the proportionate change in input is
equal to the proportionate change in output. For example, when inputs are doubled, so output should also
be doubled, then it is a case of constant returns to scale.

Diminishing Returns to Scale:

Diminishing returns to scale refers to a situation when the proportionate change in output is less than the
proportionate change in input. For example, when capital and labor is doubled but the output generated is
less than doubled, the returns to scale would be termed as diminishing returns to scale.

Key Takeaways
•Returns to scale in economics is the measure of proportional change in output with respect to the
input factors in the long run at constant technology used for the production process.
•It helps measure the efficiency of a firm and policy formation in industry categorization and allows the
maximum capacity of production of a firm.
•Its assumptions include – only two inputs, fixed technology, constant pricing, and labor plus capital used
as inputs.
•There are three types of return to scale – constant returns to scale, increasing returns to scale, and
decreasing returns to scale.
Economies of scale are cost
reductions that occur when companies
increase production. The fixed costs, like
administration, are spread over more
units of production. Sometimes, a
company that enjoys economies of scale
can negotiate to lower its variable costs,
as well.
Diseconomies of scale happen
when a company or business grows so
large that the costs per unit increase. It
takes place when economies of scale no
longer function for a firm. With this
principle, rather than experiencing In the above chart, the Y-axis represents the cost in $,
continued decreasing costs and increasing and X-axis represents production units in Q. The
output, a firm sees an increase in costs upward-facing curve represents the long-run average
cost – LRAC.
when output is increased.
 Economies of Scale – It is a state where the firm experiences the highest operational
efficiency. The LRAC of the firm keeps falling with the increase in the production of units.
 Constant Returns of Scale – The constant return of scale is a state where the firm
begins to start entering the maturity stage. At this stage, the LRAC remains static with the
increase in production.
 Diseconomies of Scale – It is a state where a firm experiences a lower operational
efficiency. That is because the LRAC keeps increasing with the increase in the production of
units.
The average cost of production ($) from the left shows a decreasing trend that reflects the
scale’s economies. The average production price in a zone of economies of scale keeps
decreasing when we have constant scale returns (represented in dotted lines).
From dotted lines, when we move towards the right, this side of the curve represents the
diseconomies of scale. The average costs ($) rise due to operational inefficiencies and other
factors as we add more production units.
Various factors influence the LRAC. For example, when a firm outgrows in size, it is common to
experience maturity or saturation. In addition, making a ground-breaking decision is not easy in
such firms because the authorities are decentralized. As a result, a decision undergoes many
approval processes before any implementation.
 Economies of scale are of two types
Internal Economies of Scale, and External Economies of Scale
Internal Economies of scale is a result of endogenous determinants, i.e. the
reasons which are internal to the firm. On the contrary, External economies of scale
occur on account of exogenous determinants, i.e. the reasons which are external to
the firm.
Comparison Chart

BASIS FOR INTERNAL ECONOMIES EXTERNAL ECONOMIES

COMPARISON OF SCALE OF SCALE

Meaning Internal economies of scale are those External economies of

scale
that arise on account of an increase in are those that arise outside
the scale of production and plant-size. the entity and accrue to the
growing entities.

Long run Falls due to the expansion in Shifts downward due to the
average cost curve output expansion in size of the
by the firm up to a certain extent industry or economy as a
whole up to a certain extent.

Reflected as Movement along the LAC curve. Shift of the LAC curve.
Internal Factors
Firms can achieve economies of scale by working over internal or controllable factors.
•Division of Labour and Specialization: Each worker should have a particular task.
Specialization improves the efficiency of individual personnel.
•Commercial: Like Walmart, many companies purchase goods in sizable quantities to avail
discounts.
•Marketing: Spending heavily on advertising and promotion is another up-scaling strategy.
Accelerated sales can easily recover the marketing cost. The marketing expenditure per unit is
miniscule.
•Technical: Technology-based companies spend excessively on Research & Development. But
they recover the investment when a successful product or service takes the market by storm.
•Financial: Large-scale businesses can get leveraged funds at a lower cost due to established
relationships and goodwill. Also, big firms can release initial public offerings (IPOs) to
raise capital.
•High Risk: Large-scale firms can afford bigger risks.
External Factors
Following are external factors that help in upscaling.
•Tax Reduction: When the government relaxes the tax liabilities on certain products or
services—demand can shoot up—higher profits for the business.
•Government Subsidies: Producers of certain goods or services receive subsidies from the
government—low production cost.
•Superior Transportation Network: Companies can take advantage of transportation
facilities by speeding up raw material procurement and finished goods distribution.
•Skilled and Talented Labour: If labor markets become efficient, companies can
employ talented workforce at nominal wages.
•Joint Ventures and Partnerships: The fastest way to scale up is via mergers and
acquisitions.
 Causes of Internal Diseconomies of Scale:
1.Bureaucracy and Management Inefficiencies: As organizations grow, they often add
layers of management to handle the increased complexity. However, this can lead to slower
decision-making processes and communication breakdowns. Each layer of management might
introduce its own approval processes, leading to delays and increased costs.
2.Coordination Breakdown: Larger organizations face challenges in coordinating activities
and aligning various departments or teams. This can result in duplication of efforts, inefficiencies,
and miscommunication, all of which contribute to increased costs.
3.Loss of Focus: Companies that expand into diverse markets or product lines can lose sight of
their core competencies. This lack of specialization can lead to inefficiencies in operations,
increased training costs, and reduced overall performance.
4.Employee Morale and Productivity: As organizations grow, employees might feel
disconnected from decision-making processes and experience reduced job satisfaction. This can
lead to decreased productivity, increased turnover rates, and higher recruitment and training
costs.
Causes of External Diseconomies of Scale:
1.Industry Congestion: As an industry grows, the demand for resources like skilled labor, raw
materials, and manufacturing facilities can exceed supply. This can drive up costs, as companies compete
for limited resources.
2.Infrastructure Constraints: Rapid industry growth might strain existing infrastructure such as
transportation networks, utilities, and supply chain systems. Overburdened infrastructure can lead to
delays, increased transportation costs, and inefficiencies in distribution
3.Talent Shortages: In certain industries, there might be a limited pool of skilled workers with specific
expertise. As demand for these workers increases, their wages rise, and companies face challenges in
recruiting and retaining skilled personnel.
4.Regulatory Burdens: As industries expand, regulators might introduce new regulations to manage
potential risks or externalities. Compliance with these regulations can be costly and time-consuming,
impacting operational efficiency and increasing costs.
Comparison:
While both internal and external diseconomies of scale result in increased costs, they stem from different
sources. Internal diseconomies arise from factors within a company's control, such as its structure and
management practices, while external diseconomies are influenced by industry-wide or external factors
that are beyond the company's direct control.
Understanding these causes helps businesses anticipate potential challenges as they grow and develop
strategies to mitigate their impact.
 Producer Surplus
Producer surplus is the difference between how much a person would be willing to accept for
a given quantity of a good versus how much they can receive by selling the good at the
market price. The difference or surplus amount is the benefit the producer receives for
selling the good in the market.
•Producer surplus is the total amount that a producer benefits from producing and selling
a quantity of a good at the market price.
•The total revenue that a producer receives from selling their goods minus the marginal
cost of production equals the producer surplus.

The Formula for Producer Surplus Is:

Total revenue - marginal cost = producer surplus

 producer surplus is that its receives at
the price point (P(i)), forming a
triangular area on the graph. The
producer’s sales revenue from selling
Q(i) units of the good is represented as
the area of the rectangle formed by the
axes, and is equal to the product of Q(i)
times the price of each unit, P(i).

Because the supply curve represents

the marginal cost of producing each
unit of the good, the producer’s total
cost of producing Q(i) units of the good
is the sum of the marginal cost of each
unit from 0 to Q(i) and is represented
by the area of the triangle under the The size of the producer surplus and its triangular depiction on
supply curve from 0 to Q(i). the graph increases as the market price for the good increases,
and decreases as the market price for the good decreases.
In a producer surplus diagram, the supply curve is often referred to as the
marginal cost curve because it helps illustrate the concept of producer
surplus in a straightforward and intuitive manner. Here's why this
terminology is commonly used:

1.Producer Surplus Definition: Producer surplus represents the difference between the
actual market price of a product or service and the minimum price (or cost) at which producers
are willing to supply that product. It is essentially the area above the supply curve and below
the market price.

2.Supply Curve Represents Marginal Cost: In many economic models and diagrams, the
supply curve is used to depict the marginal cost of production for firms. The marginal cost is
the additional cost incurred by a firm to produce one more unit of a good or service. This is
because in competitive markets, firms aim to maximize their profits by equating the market
price with their marginal cost of production.
3.Equilibrium Price: In a competitive market, the equilibrium price (where supply
equals demand) is the point where the market price (determined by the intersection of
the supply and demand curves) is equal to the marginal cost of production. This is the
price at which firms are willing to produce and sell goods because it covers their costs
and maximizes their profit.
4.Producer Surplus and Marginal Cost: In the context of producer surplus, the
use of the supply curve as the marginal cost curve helps illustrate the idea that
producers benefit when they can sell goods at a price higher than their cost of
production. The producer surplus is essentially the area above the supply curve and
below the market price.
By using the supply curve as the marginal cost curve in producer surplus diagrams, it
visually shows how producers benefit by selling goods at a price that exceeds their
production costs. It simplifies the representation of producer surplus and helps connect
it with the fundamental concept of profit maximization for firms in competitive
markets, where they equate price (market price) with marginal cost (represented by the
supply curve).