UNIT 5 MEANING OF PRODUCTION INPUT OUTPUT TRANSFORMATION

UNIT - 5

MEANING OF PRODUCTION INPUT OUTPUT TRANSFORMATION PROCESS ENTRY INTO FIRMS EXIT OF FIRMS

ØPRODUCTION means transformation of physical “ inputs” into physical “outputs”. ØINPUT refers to all those things which are required by the firm to produce a particular product. ØFour factors of production are land, labor, capital & organization. ØOUTPUT refers to the finished product. ØProduction is dependent on cost of production. ØProduction analysis shows the relationship between physical inputs & physical output. ØHigher level of production leads to higher income, employment and economic prosperity.

PRODUCTION FUNCTION Production function expresses the technological relationship between physical quantity of inputs employed and physical quantity of output obtained by a firm. Q = f (Ld, Lb, K…… etc. ) Where, Q = quantity of output Ld, Lb, K = various factors of input

TYPES OF FACTOR INPUTS 1 - FIXED INPUT are those factors who's quantity remains constant irrespective of level of output produced by a firm. Ex. Land, Building, Machine etc. 2 - VARIABLE INPUT are those factors who’s quantity varies with variation in the levels of output produced by a firm. Ex. Raw material, Power, Transport, fuel etc.

TYPES OF PRODUCTION FUNCTION SHORT RUN PRODUCTION FUNCTION In this case, producer will keep all fixed factors as constant and change only a few variable inputs. Ex. Law of variable proportions, iso–cost curves. LONG RUN PRODUCTION FUNCTION In this case, producers will vary the quantities of all factor inputs, both fixed as well as variable in the same proportion. Ex. Laws of return to scale.

THE LAW OF VARIABLE PROPORTION (production function with one variable input) As the quantity of different units of only one factor input is increased to given quantity of fixed factors, beyond a particular point, the marginal, average & total output eventually decline.

Stage no 1 - The Law of Increasing Return Stage no 2 - The Law of Diminishing Return Stage no 3 - The Stage of Negative Return

Production function with two variable inputs ISO-QUANT It may be defined as a curve which shows the different combinations of the two inputs producing the same level of output.

combinations Factor X Factor Y Total output in units A 12 1 100 B 8 2 100 C 5 3 100 D 3 4 100 E 2 5 100

ISO-QUANTS MAPS A number of ISO-QUANTS representing different amount of output are known as ISO-QUANT MAP. MARGINAL RATE OF TECHNICAL SUBSTITUTION (MRTS) It may be defined as the rate at which a factor of production can be substituted for another at the margin without affecting any change in the quantity of output.

combination Factor X Factor Y MRTS of X of Y A 12 1 Nil B 8 2 4: 1 C 5 3 3: 1 D 3 4 2: 1 E 2 5 1: 1

PROPERTIES OF ISO-QUANTS ØAn iso-curve slope downwards left to right. ØGenerally an iso-quant curve is convex to origin. ØNo two iso-product curves intersect each other. ØAn iso-product curve lying to the right represents higher output and vice-versa.

ISO-COST LINE It indicates the different combinations of the two inputs which the firm can purchase at given prices with a given outlay.

LONG RUN PRODUCTION FUNCTION LAW OF RETURN TO SCALE In return to scale, all the necessary factor inputs are increased or decreased to the same extent so that whatever the scale of production, the proportion among the factors remains the same.

THREE PHASES OF RETURN TO SCALE INCREASING RETURNS TO SCALE Y Factor ‘Y’ 350 100 Factor ‘X’ 550 200 X

CONSTANT RETURN TO SCALE FATOR ‘Y’ 400 300 200 100 Factor ‘X’

DIMINISHING RETURN TO SCALE Factor ‘Y’ 310 260 190 100 Factor ‘X’

ECONOMIES OF SCALE ØEOS is associated with large scale production. ØEOS result in cost saving. ØEOS have close relationship with the size of the firm. ØIt influences the average cost over different ranges of output. ØIt helps in reducing production cost and establishing an optimum size of firm. ØEOS are classified as- Internal & External Economies.

INTERNAL ECONOMIES (REAL ECONOMY) ØIt arise “with in” or “inside” a firm. ØIt arise due to improvements in internal factors. ØIt arise due to specific efforts of one firm. ØThese are particular to a firm & enjoyed by only one firm. ØThey arise due to increase in the scale of production. ØThey are dependent on the size of firm. ØIt can be effectively controlled by the management of the firm. ØThese are called as “BUSINESS SECRETS” of a firm.

KINDS OF INTERNAL ECONOMY ØTECHNICAL ECONOMIES §Economies of superior techniques. §Economies of increased dimension. §Economies of linked process. §Inventory economies.

ØMANAGERIAL ECONOMIES ØMARKETING or COMMERCIAL ECONOMIES ØFINANCIAL ECONOMIES ØLABOR ECONOMIES

ØTRANSPORT AND STORAGE ECONOMIES ØRISK BEARING or SURVIVAL ECONOMIES §Diversification of output §Diversification of market §Diversification of source of supply §Diversification of the process of manufacture

EXTERNAL ECONOMIES (PECUNIARY ECONOMIES) ØIt arises outside the firm. ØIt arise due to improvement in external factors. ØIt arise due to collective efforts of an industry. ØThese are general, common & enjoyed by all firms. ØIt arises due to overall development, expansion & growth of an industry or a region. ØThese are dependent on the size of industry. ØThese are beyond the control of management of a firm. ØThese are called as “open secrets” of a firm.

KINDS OF EXTERNAL ECONOMIES ØEconomies of Concentration or Agglomeration ØEconomies of Information ØEconomies of Disintegration ØEconomies of Government Action ØEconomies of Physical Factors ØEconomies of Welfare

ECONOMIES OF SCOPE Economy of scope may be defined as those benefits which arise to a firm when it produces more than one product jointly rather than producing two items separately by two different business units. C[Q 1] + C[Q 2] – C[Q 1 & Q 2] SC = C[Q 1 & Q 2]

COST OF PRODUCTION Cost of production refers to the total money expenses incurred by the producer in the process of transforming inputs into outputs.

DIFFERENT KINDS OF COST CONCEPTS ØMONEY COST AND REAL COST When cost is expressed in terms of money, ie. Called as money cost. It relates to money outlays by a firm on various factor inputs to produce a commodity. When cost is expressed in terms of physical or mental efforts put in by a person in the making of a product, it is called as real cost.

ØIMPLICIT OR IMPUTED COST AND EXPLICIT COSTS. Explicit costs are those costs which are in the nature of contractual payments and are paid by an entrepreneur to the factors of production in the form of rent, wages, interest and profits, utility expenses and payments for raw materials etc. Implicit cost are those which do not take the form of cash outlays and as such not appear in books of a/c.

ØACTUAL COSTS AND OPPORTUNITY COSTS Actual cost are those which are actual expenses incurred for producing or acquiring a commodity or service by a firm. Opportunity cost may be defined as the expected returns from the second best use of the resources which are foregone due to scarcity of resources. It is also called as alternative cost.

ØDIRECT COSTS AND INDIRECT COSTS Direct cost are those costs which can be specifically attributed to a particular product, a department, or a process of production. On the other hand, indirect cost are those costs, which are not traceable to any one unit of operation. For expayment of electricity bill, water bill, telephone bill etc.

ØPAST AND FUTURE COST Past costs are those which are spent in the previous periods. On the other hand, future cost are those which are to be spent in the future.

ØMARGINAL & INCREMENTAL COST Marginal cost is the addition to the total cost on account of producing one additional unit of the product. Or marginal cost is the cost of marginal unit produced. Incremental cost refers to the total additional cost associated with the decision to expend the output or to add a new variety of product.

ØFIXED COSTS AND VARIABLE COSTS Fixed cost are those costs which do not vary with either expansion or contraction in output. Variable costs are those costs which directly and proportionately increase or decrease with the level of output produced.

COST FUNCTION : (COST-OUTPUT RELATIONSHIP) The relation between the cost and output is technically described as the “cost function”. Cost function depends on three important variables- ØProduction function ØThe market prices of inputs ØPeriod of time

COST-OUTPUT RELATIONSHIP IN SHORT-RUN SHORT – RUN Short-run is a period of time in which only the variable factors can be varied while fixed factors like plant, machinery etc remains constant. FIXED COST ØFixed costs are those which are fixed in volume for a certain given output. ØFixed cost does not vary with variation in the output between zero and a certain given level of output.

VARIABLE COST ØVariable cost are those which vary with the variation in the total output. ØVariable cost include cost of raw material, running cost of fixed capital such as fuel, repairs, routine maintenance expenditure, direct labour charges & the cost of all other inputs.

TOTAL FIXED COST (TFC) TFC refers to total money expenses incurred on fixed inputs like plant, machinery, tools & equipments in the short – run. Y COST OF PRODUCTION TFC = TC - TVC OUTPUT X

TOTAL VARIABLE COST TVC refers to total money expenses incurred on the variable factor inputs like raw materials, power, fuel, water, transport and communication etc, in the short-run. TVC = TC - TFC COST OF PRODUCTION OUTPUT

TOTAL COST The total cost refers to the aggregate money expenditure incurred by a firm to produce a given quantity of output. TC = TFC + TVC COST OF PRODUCTION OUTPUT

AVERAGE FIXED COST (AFC) AFC is the fixed cost per unit of output. When TFC is divided by total units of output AFC is obtained. AFC = TFC / Q COST OF PRODUCTION OUTPUT

AVERAGE VARIABLE COST AVC is variable cost per unit of output. AVC can be computed by dividing the TVC by total units of output. AVC = TVC / Q COST OF PRODUCTION OUTPUT

AVERAGE COST or AVERAGE TOTAL COST AC refers to cost per unit of output. AC is also known as the unit cost since it is the cost per unit of output produced. A ATC = AFC + AVC COST OF PRODUCTION B OUTPUT AC

MARGINAL COST Marginal cost may be defined as the net addition to the total cost as one more unit of output is produced. In other words it implies additional cost incurred to produced an additional unit. MC n = TC n – TC n-1

COST OUTPUT RELATIONSHIP IN LONG RUN ØLong run is defined as a period of time where adjustments to changed conditions are complete. ØIn long run the distinction between fixed and variable costs in the total cost of production will disappear in the long run.

C O S T O F SAC 1 P R O D U C TI O N LAC SAC 2 L 1 M 2 OUTPUT

IMPORTANT FEATURES OF LONG RUN AC CURVES ØTangent curve. ØEnvelope curve. ØFlatter U- shaped or dish – shaped curve. ØPlanning curve. ØMinimum point of LAC curve should be always lower than the minimum point of SAC curve.