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BA5101 ECONOMIC ANALYSIS FOR BUSINESS
Unit II
Production – Short-run and long-run Production Function – Returns to scale – economies Vs
diseconomies of scale – Analysis of cost – Short-run and long-run cost function – Relation between
Production and cost function
MEANING OF PRODUCTION
Production is a very important economic activity. The standard of living in the ultimate analysis, depends on the volume and variety of goods and services produced in a country. In fact, the performance of an economy is judged by the level of its production. Those countries which produce goods in large quantities are rich and those which produce little of them are poor. Thus, the amount of goods and services an economy is able to produce determines the richness or poverty of that economy. The U.S.A. is a rich country just because its level of production is high. India is not so because its level of production is not very high. What exactly do we mean by production in Economics? In common parlance the term ‘production’ is used for an activity of making something material. The growing of wheat, rice or any other agricultural crop by farmers and manufacturing of cloth, radio-sets, wool, machinery or any other industrial product is often referred to as production. But in Economics the word ‘production’ is used in a wider sense. In Economics, by production we mean the process by which man utilises or converts the resources of nature, working upon them so as to make them satisfy human wants. In other words, production is any economic activity which is directed towards the satisfaction of the wants of the people by converting physical inputs into the physical output. Whether it is the making of material goods or providing any service, it is included in production provided it satisfies the wants of some people. So, in Economics, if making of cloth by an industrial worker is production, the service of the retailer who delivers it to consumers is also production. Similarly, the work of doctors, lawyers, teachers, actors, dancers, etc. is production since the services are provided by them to satisfy the wants of those who pay for them. The satisfying power of goods and services is called utility. DEFINITION Production can also be defined as creation or addition of utility. According to James Bates and J.R. Parkinson “ Production is the organized activity of transforming resources into finished products in the form of goods and services; and the objective of production is to satisfy the demand of such transformed resources”. It should be noted that production should not be taken to mean as creation of matter because according to the fundamental law of science man cannot create matter. What a man can do is only to create or add utility. When a man produces a table, he does not create the matter of which the wood is composed. He only transforms wood into a chair. By doing so he adds utility to the goods. The money expense incurred in the process of production, i.e., transforming resources into finished product constitutes the cost of production. Production consists of various processes to add utility to natural resources for gaining greater satisfaction from them by : (i) Changing the form of natural resources. Most manufacturing processes consist of taking raw material and transforming them into some items possessing utility, e.g., changing the form of a log of wood into a table or changing the form of iron into a machine. This may be called conferring utility of form. (ii) Changing the place of the resources, from the place where they are of little or no use to another place where they are of greater use. This utility of place can be obtained by : (a) extraction from earth e.g., removal of coal, minerals, gold and other metal ores from mines and supplying them to markets.
(b) transferring goods from where they give little or no satisfaction, to places where their utility is more, e.g., tin in Malaya is of little use until it is brought to the industrialised centres where necessary machinery and technology are available to produce metal boxes for packing. Another example is : apples in Kashmir orchards have some use to farmers. But when the apples are transported to markets where human settlements are thick and crowded like the city centres, they afford more satisfaction to greater number of people, rather than to the farmers in the Kashmir apple orchards. These examples only emphasise the additional utility conferred on all goods, by all forms of transportation systems, by transport workers and by the agents who assist in the movement and marketing of goods. (iii) Making available materials at times when they are not normally available e.g., harvested foodgrains are stored for use till next harvest. Canning of seasonal fruits is undertaken to make them available during off season. This may be called conferring of utility of time. (iv) Making use of personal skills in the form of services, e.g., those of organisers, merchants, transport workers etc. The fundamental purpose of all these activities is same, namely to create utility in some manner. So production is nothing but the creation of utilities in the form of goods and services. For example, in the production of a woollen suit utility is created in some form or the other. Firstly wool is changed into woollen cloth at the spinning and weaving mill (utility created by changing the form). Then it is taken to a place where it is to be sold (utility added by transporting it). Since woollen clothes are used in winter they will be retained until such time when they are required by purchasers (time utility). In the whole process, services of various groups of people are utilised (as that of mill workers, shopkeepers, agents etc.) to contribute to the enhancement of utility. Thus the entire process of
production is nothing but creation of form utility, place utility, time utility and/or personal utility.
1.FACTORS OF PRODUCTION
The process of producing goods in the modern economy is very complex. A good has to pass through many stages and many hands until it reaches the consumer’s hands in a finished form. Land, labour, capital and entrepreneurial ability are all the factors or resources whichmake it possible to produce goods and services. Even a small piece of bread cannot be produced without the active participation of these factors of production. While land is a free gift of nature and refers to natural resources, the human endeavour is classified functionally and qualitatively into three main components namely labour, capital and entrepreneurial skills. We may discuss these factors of production briefly in the following paragraphs. 1.1.0 Land : The term ‘land’ is used in a special sense in Economics. It does not mean soil or earth’s surface alone but refers to all free gifts of nature which would include besides the land, in common parlance, natural resources, fertility of soil, water, air, natural vegetation etc. It becomes difficult at times to state precisely to what part of a given factor is due solely to the gift of nature and what part belongs to human effort made on it in the past. Therefore, as a theoretical concept, we may list the following characteristics which would qualify a given factor to be called land : (i) Land is a free gift of nature. It is neither created nor destroyed by man. (ii) Land is strictly limited in quantity. It is different from the other factors of production in that, for practical purposes, it is permanently in being; no change in demand can affect the amount of land in existence. In other words, the supply of land is perfectly inelastic from the point of view of the economy. However, it is relatively elastic from the point of view of a firm. (iii) According to Ricardo, the production power of soil is indestructible in the sense that the properties of the land cannot be destroyed. Even if its fertility gets depleted it can be restored. (iv) Land cannot be shifted from one place to another place. The natural factors typical to a given place cannot be shifted to other places. It may, however be noted that man has been able to shift water from one place to another e.g. Rajasthan Canal. Land can however, be used for varied purposes though its suitability in all the uses is not the same. (v) Land is said to be a specific factor of production in the sense that it does not yield any result unless human efforts are employed. Land varies in fertility and uses.
Fixed capital is that which exists in a durable shape and renders a series of services over a period of time. For example tools, machines, etc. Circulating capital is another form of capital which performs its function in production in a single use and not available for further use. For example, seeds, raw material, etc. Real capital refers to physical goods such as building, plant, machines, etc. Human capital refers to human skill and ability. This is called human capital because a good deal of investment has gone into creation of these abilities in humans. Tangible capital can be perceived by senses whereas intangible capital is in the form of certain rights and benefits which cannot be perceived by senses. For example, goodwill, patent rights, etc. Individual capital is the personal property owned by an individual or a group of individuals. Social Capital is what belongs to the society as a whole in the form of roads, bridges, etc. PRODUCTION FUNCTION Production function states the relationship between inputs and output i.e., the maximum amount of output that can be produced with given quantities of inputs under a given state of technical knowledge. It can also be defined as the minimum quantities of various inputs that are required to yield a given quantity of output. The output takes the form of volume of goods or services and the inputs are the different factors of production i.e., land, labour, capital and enterprise. Production Function: In short, the production function is a catalogue of output possibilities. The production function can be algebraically expressed in an equation in which the output is the dependent variable and inputs are the independent variables. The equation can be expressed as:
Where ‘q’ stands for the rate of output of given commodity Q=output/quantity, LB = Land & Buildings
= Labor., K = capital = raw material= time.The production function of a firm can be studied in the
context of short period or long period. Short period or short run is that period of time which is too short for a firm to install a new capital equipment to increase production. It implies capital is a fixed factor in the short run and the production function is studied by holding the quantities of capital fixed, while varying the amount of other factors (labour, raw material etc.) Symbolically, Q = T (K, L). This is done when the law of variable proportion is derived. The production function can also be studied in the long run. The long run is a period of time (or planning horizon) in which all the factors of production are variable. It is a time period when the firm will be able to install new machines and capital equipment’s apart from increasing the units of labour. The behaviour of production when all factors are varied is the subject matter of the laws of returns to scale. Assumptions of Production Function: The production function is based on the certain assumptions;
- It is related to a particular unit of time.
- The technical knowledge during that period of time remains constant.
- The factors of production are divisible into most viable units.
- The producer is using the best technique available. Cobb-Douglas Production Function A famous statistical production function is Cobb-Douglas production function. Paul H. Douglas and C.W. Cobb of the U.S.A. studied the production function of the American manufacturing industries. In its original form, this production function applies not to an individual firm but to the whole of manufacturing in the United States. In this case, output is manufacturing production and inputs used are labour and capital. Cobb-Douglas production function
where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital. ‘K’ and ‘a’ are positive constants. The conclusion drawn from this famous statistical study is that labour contributed about 3/4th^ and capital about 1/4th of the increase in the manufacturing production. The function is linear and homogeneous. It shows constant returns to scale. ISSUES IN THE PRODUCTION THEORY 1. If all the inputs are simultaneously increased or decreased at a certain rate will the out put increase or decrease in the same proportion? 2. Supposing there are more than one process of producing a commodity, how will the output change in response to the factors of production? 3.how can the least cost combination of inputs can be achieved ?-optimum technique of production SHORT RUN PRODUCTION FUNCTION – LAW OF VARIABLE PROPORTION OR LAW OF DIMINISHING RETURNS Before discussing this law, if would be appropriate to understand the meaning of total product, average product and marginal product.
Total Product (TP) : Total product is the
total output resulting from the efforts of all the factors of production combined together at any time. If the inputs of all but one factor are held constant, total product will vary with the quantity used of the variable factor. Column (1) and (2) of Table 1 represent a total product schedule. We find that when one unit of labour is employed, the total product is 100 units. When two units of labour are employed, the total product rises to 210 units. The total product goes on rising as more and more units of labour are employed. With 10 units of labour, the total product rises to 760 units. When 11 units of labour are employed, total product falls to 740 units.
Average Product (AP) : Average product is the total product per unit of the variable factor. It is shown
as a schedule in column (3) of Table 1. When one unit of labour is employed, average product is 100, when two units of labour are employed, average product rises to 105. This goes on, as shown in Table
Marginal Product (MP) : Marginal product is the change in total product per unit change in the
quantity of variable factor. In other words, it is the addition made to the total production by an additional unit of input. The computed value of the marginal product appears in the last column of Table 1. For example, the MP corresponding to 4 units is given as 100 units. This reflects the fact that an increase in labour from 3 to 4 units increased output from 330 to 430 units.
Relationship between Average Product and Marginal Product : Both average product and marginal
product are derived from the total product. Average product is obtained by dividing total product by the units of variable factor and marginal product is the change in total product resulting from a unit increase in the quantity of variable factor. The various points of relationship between average product and marginal product can be summed up as follows : (i) when average product rises as a result of an increase in the quantity of variable input, marginal product is more than the average product. when average product is maximum, marginal product is equal to average product. In other words, the marginal product curve cuts the average product curve at its maximum.
factor are added to the constant quantity of the fixed factors then the fixed factors is more intensively and effectively utilised i.e., the efficiency of the fixed factors increases as additional units of the variable factors are added to it. This causes the production to increase at a rapid rate. For example, if a machine can be efficiently operated when four persons are working on it and if in the beginning we are operating it only with three persons, production is bound to increase if the fourth person is also put to work on the machine since the machine will be effectively utilised to its optimum. This happens because in the beginning some amount of fixed factor remained unutilised and, therefore, when the variable factor is increased, fuller utilisation of the fixed factor becomes possible and it results in increasing returns. A question arises as to why the fixed factor is not initially taken in a quantity which suits the available quantity of the variable factor. The answer is that generally those factors are taken as fixed which are indivisible. Indivisibility of a factor means that due to technological requirements a minimum amount of that factor must be employed whatever the level of output. Thus as more units of the variable factor are employed to work with an indivisible fixed factor, output greatly increases due to fuller utilisation of the latter. The second reason why we get increasing returns at the nitial stage is that as more units of the variable factors are employed, the efficiency of the variable factors itself increases. This is because with sufficient quantity of variable factor introduction of division of labour and specialisation becomes possible which results in higher productivity. Stage 2 : Law of diminishing returns : In stage 2, total product continues to increase at a diminishing rate until it reaches its maximum point H, where the second stage ends. In this stage both marginal product and average product of the variable factor are diminishing but are positive. At the end of this stage i.e., at point M (corresponding to the highest point H of the total product curve), the marginal product of the variable factor is zero. Stage 2, is known as the stage of diminishing returns because both the average and marginal products of the variable factors continuously fall during this stage. This stage is very important because the firm will seek to produce in its range. Explanation of the law : The question arises as to why we do get diminishing returns after a certain amount of the variable factor has been added to the fixed quantity of that factor. As explained above increasing returns occur primarily because of the more efficient use of fixed factors as more units of the variable factor are combined to work with it. Once the point is reached at which the amount of variable factor is sufficient to ensure efficient utilisation of the fixed factor, then further increases in the variable factor will cause marginal and average product to decline because the fixed factor then becomes inadequate relative to the quantity of the variable factor. Continuing the above example, when four men were put to work on one machine, optimum combination was achieved. Now if the fifth person is put on the machine, his contribution will be nil. In other words the marginal productivity will start diminishing. The phenomenon of diminishing returns, like that of increasing returns rests upon the indivisibility of the fixed factor. Just as the average product of the variable factor increases in the first stage when better utilisation of the fixed indivisible factor is being made, so the average product of the variable factor diminishes in the second stage when the fixed indivisible factor is being worked too hard. Another reason offered for the operation of the law of diminishing returns is the imperfect substitutability of one factor for one another. Had the perfect substitute of the scarce fixed factor been available, then the paucity of the scarce fixed factor during the second stage would have been made up by increasing the supply of its perfect substitute with the result that output could be expanded without diminishing returns. Stage 3 : Law of negative returns : In Stage 3, total product declines, MP is negative, average product is diminishing. This stage is called the stage of negative returns since the marginal product of the variable factor is negative during this stage. Explanation the law : As the amount of the variable factor continues to be increased to constant quantity of the other, a stage is reached when the total product declines and marginal product become negative. This is due to the fact that the quantity of variable factor becomes too excessive relative to the fixed factor so that they get in each other’s ways with a result that the total output falls instead of rising. In such a situation a reduction in the units of the variable factor will increase the total output.
Stage of operation : An important question is in which stage a rational producer will seek to produce. A rational producer will never produce in stage 3 where marginal product of the variable factor is negative. This being so a producer can always increase his output by reducing the amount of variable factor. Even if the variable factor is free of cost, the rational producer stops before the beginning of third stage. The rational producer will also not produce in stage 1 where the marginal product of the fixed factor is negative. The producer producing in stage 1 will not be making best use of the fixed factor and he will not be utilising fully the opportunities of increasing production by increasing quantity of the variable factor whose average product continues to rise throughout stage 1. Even if the fixed factor is free of cost in this stage, the rational entrepreneur will continue adding more variable factors. It is thus clear that a rational producer will never produce in stage 1 and stage 3. These stages are called stages of economic absurdity or economic non-sense. A rational producer will always produce in stage 2 where both the marginal product and average product of the variable factors are diminishing. At which particular point in this stage, the producer will decide to produce depends upon the prices of factors. LONG RUN PRODUCTION FUNCTION – PRODUCTION WITH 2 VARIABLE INPUTS We shall now undertake the study of production in the long run. Or we will study changes in output when all factors of production in a particular production function are increased together. In other words, we shall study the behaviour of output in response to a change in the scale. A change in the scale means that all factors of production are increased or decreased in the same proportion. Changes in scale is different from changes in factor proportions. Changes in output as a result of the variation in factor proportions, as seen before, form the subject matter of the law of variable proportions. The long run technological relationship between input and output is explained through long run production function.A simple graphical method of presenting the production is isoquant curve ISO-QUANT CURVE An Iso-quant Curve shows all the possible combinations of input factors that yield the same quantity of production. In other words, an iso-quant curve is a geometric representation of the production function, wherein different combinations of labour and capital are employed to have the same level of output. The iso-quant curve is also known as Iso-Product Curve. The term “Iso” means same and “quant” or “product” means quantity produced. Assumptions of Iso-quant Curve Only two factors of production Viz. Labor(L) and capital(K) are taken into the consideration. These factors can be substituted for each other. The factors of production can be divided into small parts. It is assumed that technology remains constant. The shape of the Iso-quant depends on the level of substitutability between the factors of production. An isoquant is a firm’s counterpart of the consumer’s indifference curve. An isoquant is a curve that shows all the combinations of inputs that yield the same level of output. ‘Iso’ means equal and ‘quant’ means quantity. Therefore, an isoquant represents a constant quantity of output. The isoquant curve is also known as an “Equal Product Curve” or “Production Indifference Curve” or Iso-Product Curve.” The concept of isoquants can be easily explained with the help of the table given below .Suppose there are two input factors Viz. Labor and Capital. The different combinations of these factors are used to have the same level of output .The above table is based on the assumption that only two factors of production, namely, Labor and Capital are used for producing 100 meters of cloth. Combination A = 5L + 9K = 100 meters of cloth Combination B = 10L + 6K = 100 meters of cloth Combination C = 15L
- 4K = 100 meters of cloth Combination D = 20L + 3K = 100 meters of cloth .The combinations A, B,
principle of diminishing marginal rate of technical substitution. MRTS is the rate at which marginal unit of an input can be substituted for another input making the level of output remain the same In figure 5, as the producer moves from point A to B, from B to C and C to D along an isoquant, the marginal rate of technical substitution (MRTS) of labor for capital diminishes. The MRTS diminishes because the two factors are not perfect substitutes. In figure 5, for every increase in labor units by (ΔL) there is a corresponding decrease in the units of capital (ΔK).. MRTS = – ΔK/ΔL = Slope of the isoquant.
4.Isoquants are negatively sloped An isoquant slopes downwards from left to right. The logic behind
this is the principle of diminishing marginal rate of technical substitution. In order to maintain a given output, a reduction in the use of one input must be offset by an increase in the use of another input. LONG RUN PRODUCTION FUNCTION - LAW OF RETURNS TO SCALE: We shall now undertake the study of production in the long run. Or we will study changes in output when all factors of production in a particular production function are increased together. In other words, we shall study the behaviour of output in response to a change in the scale. A change in the scale means that all factors of production are increased or decreased in the same proportion. Changes in scale is different from changes in factor proportions. Changes in output as a result of the variation in factor proportions, as seen before, form the subject matter of the law of variable proportions. On the other hand, the study of changes in output as a consequence of changes in scale forms the subject matter of returns to scale which is discussed here. Returns to scale may be constant, increasing or decreasing. If we increase all factors i.e., scale in a given proportion and output increases in the same proportion, returns to scale are said to be constant. Thus if a doubling or trebling of all factors causes a doubling or trebling of output, returns to scale are constant. But if the increase in all factors leads to more than proportionate increase in output, returns to scale are said to be increasing. Thus if all factors are doubled and output increases more than a double then the returns to scale are said to be increasing. On the other hand if the increase in all factors leads to less than a proportionate increase in output, returns to scale are decreasing. It is needless to say that this law operates in the long run when all the factors can be changed in some proportion simultaneously.
Constant returns to scale : As stated above, constant returns to scale means that with the increase in
the scale in some proportion, output increases in the same proportion. It has been found that production function for the economy as a whole corresponds to production function exhibiting constant returns to scale. Also, it has been found that an individual firm passes through a long phase of constant returns to scale in its lifetime. Constant return to scale is other wise called as “Linear Homogeneous Production Function” Causes of constant Returns to scale
- Limits of Economies of scale: Increasing returns to Scale cannot go on indefinitely. There is a limit to these economies of scale When the economies of scale are exhausted and diseconomies are yet to start, there may be a briefs phase of constant returns to scale.
- Divisibility of Inputs: Constant returns to scale may occur in certain productive activities where the factors of production are perfectly divisible. For example, we may double the output by setting up two plants (factories) which use the same quantity and the same type of workers, machinary, raw materials and other inputs
Increasing returns to scale : As stated earlier increasing returns to scale means that output increases in
a greater proportion than the increase in inputs. When a firm expands, increasing returns to scale are obtained in the beginning. For example, a wooden box of 3 ft. cube contains 9 times greater wood than the wooden box of 1 foot-cube. But capacity of the 3 foot- cube box is 27 times greater than that of one foot cube. Many such examples are found in real world. Another reason for increasing returns to scale is the indivisibility of factors. Some factors are available in large and lumpy units and can, therefore, be utilised with utmost efficiency at a large output. If all the factors are perfectly divisible, increasing returns may not occur. Returns to scale may also increase because of greater possibilities of specialisation of land and machinery. Causes of Increasing Returns to scale
- Indivisibilities: According to economist like Kaldor, learner, knight and Joan Robinson, an important cause of indivisibility. Indivisibility means that certain factors are available only in some minimum sizes. Certain inputs particularly machinery, management etc. are available in large and lumpy units. Such inputs cannot be divided into small sizes to suit the small scale of production. For e.g. there cannot be half a machine, half a computer or half a manager. Such inputs have to be employed even if the scale of production is small. Therefore, as the scale of production increases, these indivisible factors are utilized better and more efficiently. This leads to increasing returns to scale.
- Greater Specialization: As the scale of production increases, the efficiency of labour increases due to division of labour and specialization of labour. Similarly, when the scale of production increases, it becomes possible to use specialised machines and the services of specialized and expert management. This results in productivity of inputs leading to increasing returns to scale. According to Prof. Chamberlin returns to scale in the initial stages increases due to the fact that the firm can introduce the specialization of labour and machinery.
Decreasing returns to scale : When output increases in a smaller proportion with an increase in all
inputs, decreasing returns to scale are said to prevail. When a firm goes on expanding by increasing all inputs, then finally diminishing returns to scale set in. Decreasing returns to scale eventually occur because of increasing difficulties of management, coordination and control. When the firm has expanded to a very large size it is difficult to manage it with same efficiency as previously. Causes of Decreasing Returns to scale.
- Complexity of management: Increase in the scale of production on beyond a point may create the problem of proper management, leading to a decrease in managerial efficiency. Large scale of production creates the problem of lack of proper, larger bureaucracy, red tapism, lengthy Chain of Communication and command between the top management and men on the production line. As a consequence of all these, the overall efficiency of management decreases.
- Entrepreneur is a fixed factor: According to some economist decreasing returns to scale arise because entrepreneur is a
communication lines and so on. All these affect the efficiency and productivity of management and the firm itself.
(iii) Commercial economies and diseconomies : Production of big volumes of goods requires large
amount of material and components. This enables the firm to place a bulk order for materials and components and enjoy lower prices for them. Economies can also be achieved in selling the product. If the sales staff is not being worked to capacity, additional output can be sold at little extra cost. Moreover, large firms can benefit from economies of advertising. As scale of production increases, advertising costs per unit of output fall. In addition, a large firm may also be able to sell its by- products-something which might be unprofitable for a small firm. These economies become diseconomies after an optimum scale. For example, advertisement expenditure and other marketing overheads will increase more than proportionately after the optimum scale.
Financial economies and diseconomies : In raising finance for expansion large firm is in favourable
position. It can, for instance, offer better security to bankers and, because it is well-known, raise money at lower cost, since investors have confidence in it and prefer shares which can be readily sold on the stock exchange. However, these financial costs will rise more proportionately after the optimum scale of production. This may happen because of relatively more dependence on external finances.
(v) Risk bearing economies and diseconomies : It is said that a large business with diverse and
multi-production capability is in a better position to withstand economic ups and downs, and therefore, enjoys economies of risk bearing. However, risk may increase if diversification instead of giving a cover to economic disturbances, increases these. External Economies and Diseconomies : The use of greater degree of division of labour and specialised machinery at higher levels of output are termed as internal economies. They are internal in the sense that they accrue to the firm due to its own efforts. Besides internal economies, there are external economies which are very important for a firm. External economies and diseconomies are those economies and diseconomies which accrue to firms as a result of expansion in the output of whole industry and they are not dependent on the output level of individual firms. They are external in the sense they accrue to firms not out of their internal situation but from outside i.e. expansion of the industry. These are available to one or more of the firms in the form of :
1. Cheaper raw materials and capital equipment : The expansion of an industry may result in
exploration of new and cheaper sources of raw material, machinery and other types of capital equipment. Expansion of an industry results in greater demand for the various kinds of materials and capital equipment required by it. This makes it possible to purchase on a large scale from other industries. This reduces their cost of production and hence their prices. Thus, firms using these materials and capital equipment will be able to get them at a lower price.
2. Technological external economies : When the whole industry expands, it may result in the discovery
of new technical knowledge and in accordance with that the use of improved and better machinery than before. This will change the technical co-efficient of production and will enhance productivity of firms in the industry and reduce their cost of production.
3. Development of skilled labour : When an industry expands in an area the labour in that area is well
accustomed to do the various productive processes and learns a good deal from the experience. As a result, with the growth of an industry in an area a pool of trained labour is developed which has a favourable effect on the level of productivity and cost of the firms in that industry.
4. Growth of ancillary industries : With the growth of an industry, a number of ancillary industries may
specialise in production of raw materials, tools and machinery etc. They can provide them at a lower price to the main industry. Likewise, some firms may get developed processing the waste products of the industry and making out some useful product out of it. This will tend to reduce the cost of production in general.
5. Better transportation and marketing facilities : The expansion of an industry resulting from entry of
new firms may make possible the development of transportation and marketing network to a great extent which will greatly reduce cost of production of the firms. Similarly, communication system may get modernised resulting in better and speedy information. However, external economies may also
cease if there are certain disadvantages which may neutralise the advantages of the expansion of an industry. We call them external diseconomies. An example of external diseconomies is the rise in some factor prices. When an industry expands, the requirement of the various factors of production increases; for example, that of all raw materials, capital goods, skilled labour and so on. This may result in pushing up the prices of such factors of production specially when they are short in supply. Moreover, too many firms in an industry at one place may also result in higher transportation cost, marketing cost and high pollution control cost. The government may also through its locational policy prohibit or restrict expansion of an industry at a particular place.
THEORY OF COST
COST ANALYSIS
Cost analysis refers to the study of behaviour of cost in relation to one or more production criteria, namely, size of output, scale of operations, prices of factors of production and other relevant economic variables. In other words, cost analysis is concerned with financial aspects of production relations as against physical aspects which were considered in production analysis. In order to have a clear understanding of the cost function it is important to understand various concepts of costs. COST CONCEPTS Accounting costs and economic costs : When an entrepreneur undertakes an act of production he has to pay prices for the factors which he employs for production. He thus pays, wages to workers employed, prices for the raw materials, fuel and power used, rent for the building he hires, and interest on the money borrowed for doing business. All these are included in his cost of production and are termed as accounting costs. Thus accounting costs take care of all the payments and charges made by the entrepreneur to the suppliers of various productive factors. Outlay costs and opportunity costs : Outlay costs involve actual expenditure of funds on, say, wages, material, rent, interest, etc. Opportunity cost, on the other hand, is concerned with the cost of foregone opportunity; it involves a comparison between the policy that was chosen and the policy that was rejected. For example, opportunity cost of using capital is the interest that it can earn in the next best use of equal risk. A distinction between outlay costs and opportunity costs can be drawn on the basis of the nature of the sacrifice. Outlay costs involve financial expenditure at some time and hence are recorded in the books of account. Opportunity costs relate to sacrificed alternatives; they are not recorded in the books of account in general. The opportunity cost concept is generally very useful, e.g., in a cloth mill which spins its own yarn, the opportunity cost of yarn to the weaving department is the price at which the yarn could be sold, for measuring profitability of the weaving operations. In long-term cost calculation also it is useful e.g., in calculating the cost of higher education, it is not the tuition fee and books but the earning foregone that should be taken into account. Direct or traceable costs and indirect or non-traceable costs; Direct costs are costs that are readily identified and are traceable to a particular product, operation or plant. Even overhead can be direct as to a department; manufacturing costs can be direct to a product line, sales territory, customer class etc. We must know the purpose of cost calculation before considering whether a cost is direct or indirect. Indirect costs are not readily identified nor visibly traceable to specific goods, services, operation, etc. but are nevertheless charged to the jobs or products in standard accounting practice. The economic importance of these costs is that these, even though not directly traceable to the product, may bear some functional relationship to production and may vary with output in some definite way. Examples of such costs are electric power, the common costs incurred for general operation of business benefiting all products jointly. Fixed and variable costs : Fixed or constant costs are not a function of output; they do not vary with output upto a certain level of activity. These costs require a fixed expenditure of funds irrespective of the level of output, e.g., rent, property taxes, interest on loans, depreciation when taken as a function of time and not of output. However, these costs also vary with the size of the plant and are a function of capacity. Therefore, fixed costs do not vary with thevolume of output within a capacity level. Fixed costs cannot be avoided. These costs are fixed so long as operations are going on. They can be avoided only when operations are completely closed down. We can call them as inescapable or uncontrollable
cannot be expected to be absolutely correct figures. Past costs serve as the basis for projecting future costs. In periods of inflation and deflation, the two cost concepts differ significantly. Managerial decisions are always forward looking and therefore they require estimates of future costs and not past costs. Unlike past costs, future costs are subject to management control and they can be planned or avoided. If the future costs are considered too high, management can either plan to reduce them or find out ways and means to meet them. Management needs to estimate future costs for a variety of reasons such as expense control pricing, projecting future profits and capital budgeting decisions. When historical costs are used instead of explicit projections, the assumption is made that future costs will be the same as past costs. In periods of significant price variations, such an assumption may lead to wrong managerial decisions. Private Costs and Social Costs A further distinction that is useful to make - especially in the public sector - is between private and social costs. Private costs are those that accrue directly to the individuals or firms engaged in relevant activity. Social costs, on the\ other hand, are passed on to persons not involved in the activity in any direct way (i.e., they are passed on to society at large). Consider the case of a manufacturer located on the bank of a river who dumps the waste into water rather than disposing it of in some other manner. While the private cost to the firm of dumping is zero, it is definitely harmful to the society. It affects adversely the people located down current and incur higher costs in terms of treating the water for their use, or having to travel a great deal to fetch potable water. If these external costs were included in the production costs of a producing firm, a true picture of real, or social costs of the output would be obtained. Ignoring external costs may lead to an inefficient and undesirable allocation of resources in society. Relevant Costs and Irrelevant Costs The relevant costs for decision-making purposes are those costs, which are incurred as a result of the decision under consideration. The relevant costs are also referred to as the incremental costs. Costs that have been incurred already and costs that will be incurred in the future, regardless of the present decision are irrelevant costs as far as the current decision problem is concerned. There are three main categories of relevant or incremental costs. These are the present-period explicit costs, the opportunity costs implicitly involved in the decision, and the future cost implications that flow from the decision. For example, direct labour and material costs, and changes in the variable overhead costs are the natural consequences of a decision to increase the output level. Also, if there is any expenditure on capital equipments incurred as a result of such a decision, it should be included in full, not withstanding that the equipment may have a useful life remaining after the present decision has been carried out. Thus, the incremental costs of a decision to increase output level will include all present-period explicit costs, which will be incurred as a consequence of this decision. It will exclude any present-period explicit cost that will be incurred regardless of the present decision. The opportunity cost of a resource under use, as discussed earlier, becomes a relevant cost while arriving at the economic profit of the firm. Many decisions will have implications for future costs, both explicit and implicit. If a firm expects to incur some costs in future as a consequence of the present analysis, such future costs should be included in the present value terms if known for certain. Sunk costs and incremental cost Sunk costs are expenditures that have been made in the past or must be paid in the future as part of contractual agreement or previous decision. For example, the money already paid for machinery, equipment, inventory and future rental payments on a warehouse that must be paid as part of a long term lease agreement are sunk costs. In general, sunk costs are not relevant to economic decisions. For example, the purchase of specialized equipment designed to order for a plant. We assume that the equipment can be used to do only what it was originally designed for and cannot be converted for
alternative use. The expenditure on this equipment is a sunk cost. Also, because this equipment has no alternative use its opportunity cost is zero and, hence, sunk costs are not relevant to economic decisions. Sometimes the sunk costs are also called as non-avoidable or non- escapable costs. On the other hand, incremental cost refers to total additional cost of implementing a managerial decision. Change in product line, change in output level, adding or replacing a machine, changing distribution channels etc. are examples of incremental costs. Sometimes incremental costs are also called as avoidable or escapable costs. Moreover, since incremental costs may also be regarded as the difference in total costs resulting from a contemplated change, they are also called differential costs. As stated earlier sunk costs are irrelevant for decision making, as they do not vary with the changes contemplated for future by the management. COST FUNCTION The cost function refers to the mathematical relation between cost of a product and the various determinants of costs. In cost function, the dependent variable is unit cost or total cost and the independent variables are the price of a factor, the size of the output or any other relevant phenomenon which has a bearing on cost such as technology, level of capacity utilization, efficiency and time period under consideration. SHORT RUN TOTAL COSTS Total, fixed and variable costs : There are some factors which can be easily adjusted with changes in the level of output. Thus a firm can readily employ more workers if it has to increase output. Similarly, it can purchase more raw material if it has to expand production. Such factors which can be easily varied with a change in the level of output are called variable factors. On the other hand, there are factors such as building, capital equipment, or top management team which cannot be so easily varied. It requires comparatively longer time to make changes in them. It takes time to install a new machinery. Similarly, it takes time to build a new factory. Such factors which cannot be readily varied and require a longer period to adjust are called fixed factors. Corresponding to the distinction between variable and fixed factors we distinguish between short run and long run periods of time. Short run is a period of time in which output can be increased or decreased by changing only the amount of variable factors, such as labour, raw material, etc. In the short run, quantities of fixed factors cannot be varied in accordance with changes in output. If the firm wants to increase output in the short run, it can do so only with the help of variable factors, i.e., by using more labour and/or by buying more raw material. Thus, short run is a period of time in which only variable factors can be varied, while the quantities of fixed factors remain unaltered. On the other hand, long run is a period of time in which the quantities of all factors may be varied. Thus all factors become variable in the long run. Thus we find that fixed costs are those costs which are independent of output, i.e., they do not change with changes in output. These costs are a “fixed amount” which are incurred by a firm in the short run, whether the output is small or large. Even if the firm closes down for some time in the short run but remains in business, these costs have to be borne by it. Fixed costs include such charges as contractual rent, insurance fee, maintenance cost, property taxes, interest on capital employed, manager’s salary, watchman’s wages etc. Variable costs on the other hand are those costs which change with changes in output. These costs include payments such as wages of labour employed, prices of raw material, fuel and power used, transportation cost etc. If a firm shuts down for a short period, then it may not use variable factors of production and will not therefore incur any variable cost.
Marginal Cost : Marginal cost is the addition made to the total cost by production of an additional unit of output. In other words, it is the total cost of producing t units instead of t- 1 units, where t is any given number. For example, if we are producing 5 units at a cost of Rs. 200 and now suppose 6th unit is produced and the total cost is Rs. 250, marginal cost is Rs. 250 - 200 i.e., Rs. 50. It is to be noted that marginal cost is independent of fixed cost. This is because fixed costs do not change with output. It is only the variable costs which change with a change in the level of output in the short run. Therefore, marginal cost is in fact due to the changes in variable costs. Symbolically margical cost can be written as : Marginal cost curve falls as output increases in the beginning. It starts rising after a certain level of output. This happens because of the influence of the law of variable proportions. The fact that marginal product rises first, reaches a maximum and then declines ensures that the marginal cost curve of a firm declines first, reaches its minimum and then rises. In other words marginal cost curve of a firm is “U” shaped (see Figure 10). The behaviour of these costs has also been shown in Table 2. The above table shows that : (i) Fixed cost does not change with increase in output upto a given range. Average fixed cost, therefore, comes down with every increase in output. (ii) Variable cost increases but not necessarily in the same proportion as the increase in output. In the above case, average variable cost comes down gradually till 55 units are produced. (iii) Marginal cost is the additional cost divided by addition units produced. This also comes gradually till 44 units are produced. Relationship between Average Cost and Marginal Cost : The relationship between marginal cost and average cost is the same as that between any other marginal average quantities. The following are the points of relationship between the two phenomena. (1) When average cost falls as a result of an increase in output, marginal cost is less than average cost. (2) When average cost rises as a result of an increase in output, marginal cost is more than average cost. (3) When average cost is minimum, marginal cost is equal to the average cost. In other words, marginal cost curve cuts average cost curve at its minimum point (i.e. optimum point). Figure 10 and Table 2 confirm the above points of relationship. LONG RUN AVERAGE COST CURVE As stated above long run is a period of time during which the firm can vary all of its inputs - unlike short run in which some inputs are fixed and others are variable. In other words, whereas in the short run the firm is tied with a given plant, in the long run the firm moves from one plant to another; it can acquire a big plant if it wants to increase its output and a small plant if it wants to reduce its output. Long run cost of production is the least possible cost of producing any given level of output when all
individual factors are variable. A long run cost curve depicts the functional relationship between output and the long run cost of production. In order to understand how long run average cost curve is derived we consider three short run average cost curves as shown in Figure 11. These short run cost curves (SACs) are also called plant curves. In the short run the firm can be operating on any short run average cost curve given the size of the plant. Suppose that these are the only three plants which are technically possible. Given the size of the plant, the firm will be increasing or decreasing its output by changing the amount of the variable inputs. But in the long run, the firm chooses among the three possible sizes of plants as depicted by short run average curve (SAC1, SAC2, SAC3). In the long run, the firm will examine with which size of plants or on which short average cost curve it should operate to produce a given level of output so that total cost is minimum. It will be seen from the diagram that upto OB amount of output the firm will operate on the SAC1, though it could also produce with SAC2, because upto OB amount of output, the production on SAC1 results in lower cost than on SAC2. For example, if the level of output OA is produced with SAC1, it will cost AL per unit and if it is produced with SAC2 it will cost AH and we can see that AH is more than AL. Similarly, if the firm plans to produce an output which is larger than OB but less than OD then it will not be economical to produce on SAC1. For this, the firm will have to use SAC2. Similarly, the firm will use SAC3 for output larger than OD. It is thus clear that in the long run the firm has a choice in the employment of plant and it will employ that plant which yields minimum possible unit cost for producing a given output Suppose now, the firm has a choice so that a plant can be varied by infinitely small gradations so that there are infinite number of plants corresponding to which there numerous average cost curves. In such a case the long run average cost curve will be a smooth curve enveloping all these short run average cost curves. As shown in Figure 12 the long run average cost curve is so drawn as to be tangent to each of the short run average cost curves. Every point on the long run average cost curve will be a tangency point with some short run AC curve. If a firm desires to produce any particular output it then builds a corresponding plant and operate on the corresponding short run average cost curve. As shown in the figure, for producing OM the corresponding point on the LAC curve is G and the short run average cost curve SAC2 is tangent to the long run AC at this point. Thus if a firm desires to produce output OM, the firm will construct a plant corresponding to SAC2 and will operate on this curve at point G. Similarly, the firm will produce other levels of output choosing the plant which suits its requirements of lowest possible cost of production. It is clear from the figure that the large output can be produced at the lowest cost with the larger plant whereas smaller output can be produced at the lowest cost with smaller plants. For example, to produce OM, the firm will be using SAC2 only; if it uses SAC3 for this, it will result in higher unit cost than SAC2. But larger output OV can be produced most economically with a larger plant represented by the SAC3. If we produce OV with the smaller plant it will result in higher unit similarly if we produce larger output with a smaller plant it will involve higher cost because of its limited capacity. It is to be noted that LAC curve is not a tangent to the minimum points of the SAC curves. When the LAC curve is declining it is tangent to the falling portions of the short run cost curves and when the LAC curve is rising it is tangent to the rising
