Lecture 6

Lecture 6Scale of Production

Scale of Production• The scale of production has an important

bearing on the cost of production• It is the manufacturers common experience

that larger the scale of production – The lower generally is the cost of production

• That is why entrepreneur is tempted to enlarge the scale of production so that he may benefit from resulting economies of scale

• These economies are of two types– External economies– Internal economies

Economies of Large Scale Production• Efficient Use of Capital Equipment– There is large scope for the use of machinery which results in lower costs• Economy of Specialized Labour– Specialized labour produces a larger output and of better quality• Better Utilisation and Greater Specialization in Management– a capable manager is under-utilized in a small concern• Economies of Buying and Selling– Good rates while buying raw materials and high net profits on large sales • Economies of Overhead Charges– The expenses of administration and distribution per unit are much less in big units• Economy in Rent– A large-scale producer makes a saving in rent too • Experiments and Research– Big concerns can spend a lot on research activities which pay back in long run• Advertisement and Salesmanship– Can spend on advertisement• Utilization of By-products– By products can be utilized in big concerns• Meeting Adversity– A big business can show resistance in time of adversity• Cheap Credit– Bank give cheap credit to big concerns

Diseconomies of Scale• Overworked Management

– A large scale producer cannot pay attention to every detail• Individual tastes Ignored

– Large scale of production is of uniform quality so individual tastes are ignored• No Personal Element

– Managed by employees so no personal interest• Possibility of depression

– Large scale production may result in over production• Dependence on foreign markets

– Large scale of production is normally dependent on foreign markets• Cut-throat competition

– large scale producers fight for markets• International complications and war

– Large scale production at international level may give rise to international conflicts and may lead to war

• Lack of adaptability – It is difficult for large scale units to shift from one business to another while

easy for small business

Types of Economies

• Internal Economies• External Economies

Internal Economies• Internal Economies are those economies in production

or reduction in production costs– Which accrue to the firm itself when it expands its output or

enlarges its scale of production• The internal economies arise with a firm as a result of

its own expansion independent of the size and expansion of the industry

• Internal economies may be of the following types– Technical economies– Managerial economies– Commercial economies– Financial economies– Risk-bearing economies

Technical Economies• There are four ways in which technical

economies can arise– Large size• Economies arise when large machines are used

– E.g. big boiler, big furnace

– Linking process• A dairy may have its own fodder farm or a sugar factory

has its own sugarcane farm

– Superior technique• Superior technologies

– Increased specialization• Specialization and division of labour are advantageous

Managerial Economies

• These economies arise from the creation of special departments or from functional specialization

• They are also resulted from delegation of routine and detailed matters to subordinates

• This is vertical division of labor. However there can be horizantal division of labour– By placing each division under an expert

Commercial Economies

• They arise from the purchase of materials and sale of goods– Large businesses have bargaining advantages and

are accorded a preferential treatment by the firms they deal with• They are able to secure freight concessions from

railway and road tranport• Cheap credit from banks• Prompt delivery • Careful attention

Financial Economies

• These economies arise form the fact that a big firm has better credit and can borrow on more favourable terms.

Risk-bearing Economies

• A big firm can spread risks and can often eliminate them

• This is done by diversifying output• Diversification imparts it strength and stability

and takes it less vulnerable to changes in commercial fortunes

External Economies

• External economies are those economies which accrue to each member firm as a result of the expansion of the industry as a whole

• Expansion of an industry may lead to the availability of new and cheaper raw materials, tools and machinery and discovery and diffusion of a superior technical knowledge

• There are various types of external economies– Economies of concentration– Economies of information– Economies of disintegration

Economies of Concentration

• These economies relate to advantages arising from the availability of – Skilled workers– The provision of better transport and credit

facilities– Stimulation of improvements– Benefits from subsidries

• Scattered firms do not enjoy such economies

Economies of Information

• These economies refer to the benefits which all firms engaged in an industry derive – From the publication of trade and technical

journals and – from central research institute

• Each individual need not incur expenditure on research. It can draw such benefits from common pool

Economies of Disintegration

• When an industry grows, it becomes possible to split some of the processes which are taken over by specialist firms

Relationship between IE and EE

• No hard and fast line can be drawn between the two • Internal economies are the result of expansion of

individual firms while external economies are the result of expansion or development of whole industry

• There can also be diseconomies if some inefficient factors are brought in while expansion in a firm or in an industry

• If scale of production is increased it brings in economies of scale. However, if it is increased beyond limits the economies of scale would be converted in diseconomies of scale

Production Possibility Curve&

Production Function

Production Possibility Curve

• The production possibility curve shows the maximum out put of any one commodity that the economy can produce together with the prescribed quantities of other commodities produced and resources utilized

• In short, the production possibility curve tells us what assortment of goods and services the economy can produce with the resources and techniques at its disposal

ExampleProduction Possibilities Goo1d X

(thousands)Good Y

(thousands)

A 0 15

B 1 14

C 2 12

D 3 9

E 4 5

F 5 0

Production Possibility Curve

• A curve depicting all maximum output possibilities for two or more goods given a set of inputs (resources, labor, etc.). The PPF assumes that all inputs are used efficiently

• At point X resources are not being efficiently utilized• Point Y is not reachable under given resources

Marginal Rate of Transformation• In order to produce more X we must sacrifice

some Y• The rate at which one product is transformed into

another is called marginal rate of transformation• For instance marginal rate of transformation

between good X and good Y is the amount of Y which has to be sacrificed for the production of X

• The MRT increases as Y is produced more and more . That is why the production possibility curve is concave

Iso-Revenue Line• The iso-revenue line is the bundles of outputs

that return the same level of revenue.– It represents the rate at which the market is

willing to exchange one product for another.

Production Function• Production Function may be defined as the functional relationship between

physical inputs (i.e. factors of production) and physical outputs (i.e. the quantity of goods produced)

• It shows the maximum amount of output which can be produced from a given set of inputs in the existing state of technology

• Production function depends on – Quantities of resources used– State of technical knowledge– Possible processes– Size of the firms– Nature of firm’s organization– Relative prices of the factors of production and the manner in which these factors are

combined• With the change of these factors production function will also change• Production Function can be expressed as

– X=f(a, b, c, d, ……..)• X is the output of a commodity per unit of time • a,b,c,d are the various productive resources• f is the fucntion

Important Points in PF

• Purely technical relationship– Input with output – No reference to money price

• The output is the result of a joint use of the factors of production

• The combination of inputs depends on technology

• Variability of the factors of production is considered while defining production function

Types of Production Function• Fixed Proportion Production Function– Factors of production are used in definite fixed

proportions– For example a fixed number of workers are

required to produce a given unit of output. This proportion cannot be varied by substituting one factor for another

• Variable Proportion Production Function– The technical coefficient of production is variable – Substitution of factors possible

Quiz• What an indifference curve shows and why it

is convex to the origin?

• Show Income Effect, Price Effect and Substitution Effect through indifference curve analysis and explain it?

• What is elasticity of demand? Please Explain different cases and types of elasticity of demand.