Business Economics

CA Foundation Business Economics Study Material Chapter 3 Theory of Production and Cost – Internal and External Economies

Internal Economies and Diseconomies

• Internal economies are those benefits which accrue to a firm when it expands the scale of production.
• Internal economies are the result of the firm’s own efforts independent of the actions of other firms.
• These economies are particular to the individual firms and are different for different firms depending upon the size of the firm.

The main types of internal economies are as follows

1. Technical Economies:

– The large scale production is associated with technical economies.
– As the firm increases its scale of production, it becomes possible to use better plant, machinery, equipment and techniques of production.
– Following are the main forms (causes/reasons) of technical economies

• Economies of superior techniques
  – A large sized firm can use sophisticated and costly machines and equipments.
  – Use of superior techniques reduces the cost of production per unit and increases aggregate output.
• Economies of increased dimensions
  – A large firm can get the mechanical advantage in using large machines and other mechanical units to produce more output.
  – E.g. A Large boiler, large furnace, etc. can be operated by same team as required by smaller boiler, furnace, etc.
• Economies of linked processes
  – A large sized firm can develop its own sources of raw material, means of transportation, distribution system, etc.
• Economies of the use of By-products
  – A large sized firm can avoid all kinds of wastage of materials. The firm can use its by- products and waste material to produce another material.
  – E.g.- Sugar industry can make alcohol out of the molasses.
• Economies of specialization
  – A large sized firm can introduce greater degree of division of labour and specialisation.

2. Managerial Economies:

• Large sized firms can introduce division of labour in managerial tasks.
• They can employ business executive of high skill and qualification to look after the functioning of various departments like production, finance, sales, advertising, personnel, etc.
• This helps to increase the efficiency and productivity of managers resulting in reduction in managerial costs.

3. Commercial Economies:

• A large sized firm is able to reap economies of bulk purchases.
• It can get discounts from suppliers, railways, transport companies, etc.
• It enjoys prompt and regular supply of raw materials.
• A large sized firm can also afford to spend large amount of money on advertising, publicity, etc.
• It can also give various concessions to wholesale and retail dealers and customers and thus capture markets for its product.

4. Financial Economies:

• A big firm enjoys goodwill among lenders or investors.
• For raising finance it can either borrow from bank as it can offer better security or it can raise finance by issuing shares, debentures and by inviting public deposits. Such opportunities are not available to small firms.

5. Risk Bearing Economies:

• A large firm is better placed to face the uncertainties and risks of business.
• A big firm producing many variety of goods is in a better position to withstand economic ups and downs. Therefore, it enjoys economies of risk bearing.

Internal diseconomies means all those factors which raise the cost of production per unit of a particular firm when the scale of production is expanded beyond the point of optimal capacity.

Such diseconomies of scale are as follows

1. Production Diseconomies:

• Production diseconomies sets in when expansion of firm’s production beyond optimum size leads to rise in the cost per unit of output.
• E.g. Use of inferior or less efficient factors due to non-availability of efficient factors raises the per unit cost of output.

2. Managerial Diseconomies:

• As the scale of production increases burden on management also increases.
• Co-ordination of work among different departments becomes difficult. Supervision and control over the activities of subordinates becomes difficult, decision taking is delayed, etc.
• As a result, wastage increase and the efficiency and productivity decrease.
• Per unit cost starts rising.

3. Technical Diseconomies:

• Every equipment has an optimum point at which it works more efficiently and economically.
• Beyond optimum point they are overworked and may result in breakdowns, heavy cost of maintenance, etc.

4. Financial Diseconomies:

• Expansion of production beyond the optimum scale results in increase in the cost of capital.
• It may be due to increased dependence on external finances.

5. Marketing Diseconomies:

• Selling diseconomies set in if the scale of production is expanded beyond optimum level.
• The advertisement expenditure and marketing overheads increase more proportionately with the scale.

External Economies and Diseconomies

• External economies are those benefits which accrue to all the firms operating in a given industry from the growth and expansion of that industry.
• External economies are not related to an individual firm’s own cost reduction efforts.
• These are common to all the firms in an industry and shared by many firms or industries.

The main types of external economies are as follows

1. Technological Economies:

• When the whole industry expands, it may result in the discovery of new technical knowledge, firms pool manpower and finance for research and development resulting in new and improved methods of production and new inventions.
• Use of improved and better machinery improves production function and cost of production per unit falls.

2. Economies of Localization:

• When in an area, many firms producing the same commodity are set up, it is called localization of an industry.
• Due to localization there is expansion of railways, post & telegraph, banking services, insurance, setting up of booking offices by transport, companies, setting § up of powerful transformer by electricity department, etc.
• All the firms get these facilities at low prices.

3. Economies of Information:

• As pointed earlier, firms pool their resources for research and development.
• All firms get the benefit of the research in terms of market information, technical information, information about governments economic policies, information about availability of new source of raw material, etc.
• Also, specialized journals give information about latest developments.

4. Cheaper Inputs:

• When an industry expands its needs for raw materials, machines, etc. also expand.
• This may result in exploration of new and cheaper sources of raw materials, machinery, etc.
• Also, the industries producing such inputs also expand in scale.
• Therefore, they can supply these inputs at lower prices.
• As a result the cost of production per unit of the firm using these inputs falls.

5. Growth of Ancillary Industries:

• With the growth of an industry, many firms specialized in the production of inputs like raw material, tools, machinery, etc. come up.
• Such firms are called ancillary units which provides inputs at lower cost to the main industry.
• Likewise, some firms may get developed by processing the waste products of the industry.
• Thus, wastes are converted into by-products. This reduces the cost of production in general.

6. Development of Skilled Labour:

• When an industry expands specialized institutions like colleges, training centers, management institutes, etc. develop.
• This results in continuous availability of skilled labour like technicians, engineers, management experts, etc.

7. Better transportation & Marketing Facilities:-

• When an industry expands many specialized transporters also develop.
• The firm in need of specialized transport service can get them easily at cheaper rates.
• Also many new marketing outlets and specialized marketing institutions develop. The firm need not spend on developing its own marketing outlets.
• This reduces the cost.

The growth and expansion of an industry in a particular area beyond optimum level results in many disadvantages for firms in the industry. Such disadvantages increases the costs of production of each firm. Therefore, they are called external diseconomies. Some of the external diseconomies are as follows:

1. Diseconomies of Scarcity of Inputs:

• When an industry expands its need for raw materials, machines, tools and equipments, etc. also expands.
• Some inputs are such which cannot be totally substituted.
• The firms supplying these inputs come under pressure and may supply inputs at a higher price.
• This raises the cost of production per unit of the firm who uses these inputs.

2. Diseconomies of Strains on Infrastructure:

• Due to concentration of firms in an area infrastructural facilities become inadequate over a time.
• E.g. Excessive pressure on transport system results in delayed transportation of raw materials and finished goods.
• Other facilities like electric power supply, communication system, water supply, etc. are also over taxed.
• This puts strain on infrastructural facilities resulting in increased cost of production. ’

3. Diseconomies of High Factor Prices:

• With the concentration of an industry in a particular area, the demand for factors of production rises.
• Thus, the prices of the factors of production go up resulting in increased cost of production.

4. Diseconomies of Expenditure on Advertising:

• Expansion of an industry also means increase in the number of firms.
• This means increase in competition among the firms.
• This forces a firm to spend more and more on advertising.
• This raises per unit cost.

Internal and External Economies

S.No	INTERNAL ECONOMIES	EXTERNAL ECONOMIES
1.	Internal economies are the benefits which accrue to a firm when it expands the scale of production.	External economies are those benefits which accrue to all the firms operating in a given industry from the growth and expansion of that industry.
2.	Internal economies are called ‘internal’ because these arise due to the internal efforts of the firm. These economies are specific to the individual firm and are different for different firms depending upon the size of the firm.	External economies are called ‘external’ because they accrue to a firm as a result of factors that are entirely outside the firm i.e. from the expansion of the industry.
3.	Internal economies are the result of the firm’s OWN EFFORTS INDEPENDENT OF THE ACTIONS OF OTHER FIRMS. These economies are peculiar to each fir m. It reflects the working pattern of the firm.	External economies are independent of firm’s own efforts and output. They are dependent on the general development of the industry. They are not restricted to a single firm but are shared by a number of firms.
4.	Internal economies cause the long-run average cost to fall in the initial stage and internal diseconomies cause the long-run average cost to rise at the later stage. Thus, the shape of LAC curve is determined by internal economies and diseconomies as scale expands.	External economies and diseconomies cause the LAC curve to shift down or up as the case may be. When external economies increase, the cost per unit of output falls. So, LAC curve shift downwards. When external diseconomies are more, the cost per unit of output rises. So, LAC curve shift upwards.
5.
6.	If every thing is effectively managed, internal economies can be of long term in nature.	External economies depend upon the conditions of the entire industry and economy. Thus, it can be of short term in nature.
7.	Internal economies are in the form of technical economies like superior techniques, use of by- products, etc.; managerial economies; commercial economies; financial economies and risk-bearing economies.	External economies are in the form of cheaper inputs; discovery of new technical knowledge; development of skilled labour; economies of information; growth of ancillary units; better transport and marketing facilities.

CA Foundation Business Economics Study Material Chapter 3 Theory of Production and Cost – Production Optimisation

Production Optimisation
Isoquants:

An iso-product curve or isoquant is a curve, which represents the various combinations of two variable inputs that give the same level of output. As all combinations on the iso-product curve give the same level of output, the producer becomes indifferent to these combinations. That is why iso-product curve are also called ‘production indifference curve’ or ‘equal product curve’. To understand consider the following production isoquant schedule.

In the schedule I above, the producer is indifferent whether he gets combination A, B, C, D or E. This is because all the combinations of capital and labour give the same level of output i.e. 100 units.

By plotting the above combinations on a graph, we can derive an iso-product curve as shown in the following figure:

In the diagram, quantity of capital is measured on X-axis and quantity of labour on Y-axis.

The various combinations A, B, C, D, E of capital and labour are plotted and on joining them we derive an iso-product curve. All combinations lying on the iso-product curve yield the same level of output i.e. 100 units and hence technically equally efficient.

If the production schedule II is also plotted on the graph, we will get another iso-product curve IQ₂₀₀. This will lie above the IQ₁₀₀ as the combinations contain greater quantities of capital and labour. A set of iso-product curves is called iso-product curve map.

In the diagram, it can be observed that each iso-product curve is labelled in terms of output. All combinations lying of IQ₁₀₀ give the output of 100 units and all the combinations lying on IQ₂₀₀ give the output of 200 units. Higher iso-product curve represent higher level of output. Also it indicates how much more output can be achieved.

Marginal Rate of Technical Substitution
The rate at which one factor of production is substituted in place of the other factor without any change in the level of output is called as the marginal rate of technical substitution. Consider the following schedule.

Each of the factor combinations in the table above yields same level of output. Moving from combination A to B, one unit of capital replaces 4 units of labour. Similarly, moving from B to C, one unit of capital now replaces only 3 units of labour and so on. It implies that labour and capital are imperfect substitutes. That is why MRTS_KL is continuously diminishing. We can measure MRTS_KL on an iso-product curve.

‘Iso-Cost Line’ OR ‘Equal Cost Lines’
Iso-cost line (also known Equal Cost Line; Price Line; Outlay Line; Factor Price Line) shows the various combinations of two factor inputs which the firm can purchase with a given outlay (i.e. budget) and at given prices of two inputs.

Example. A firm has with itself Rs. 1,000 which it would like to spend on factor ‘X’ and factor ‘Y’.
Price of factor ‘X’ is Rs. 20 per unit.
Price of factor ‘Y’ is Rs. 10 per unit.
Therefore, if the firm spends the whole amount on factor X, it can buy 50 units of X and if the whole amount is spent on factor Y, it can buy 100 units of Y. However, in between these two extreme limits, it can have many combinations of X and Y for the outlay of Rs. 1,000. Graphically it can be shown as follows –

In the diagram OP shows 100 units of Y and OM shows 50 units of X. When we join the two points P and M, we get the iso-cost line. All the combinations of factor X and factor Y lying on iso-cost line can be purchased by the firm with an outlay of Rs. 1,000. If the firm increases the outlay to Rs. 2,000, the iso-cost line shifts to the right, if prices of two factors remains unchanged. The slope of the iso-cost line is equal to the ratio of the prices of two factors. Thus,

Producer’s Equilibrium OR Production Optimization
A firm always try to produce a given level of output at minimum cost. For this it has to use that combination of inputs which minimizes the cost of production. This ensures maximization of profits and produce a given level of output with least cost combination of inputs. The least-cost combination of inputs or factors is called producer’s equilibrium or production optimization. This is determined with the help of (a) isoquants, & (b) iso-cost line.

An isoquant or iso-product curve is a curve which shows the various combinations of two inputs that produce same level of output. The isoquants are negatively sloped and convex to origin. The slope of isoquants shows the marginal rate of technical substitution which diminishes. Thus, MRTS_xy

Iso-cost line shows the various combination of two factor inputs which the firm can purchase with a given outlay and at given prices of inputs. There can be different outlays and hence different iso-cost lines. Slope of iso-cost line shows the ratio of the price of two inputs i.e. P_x/P_y

Which will be the least cost combination can be understood with the help of following figure. Suppose firm wants to produce 300 units of a commodity. It will first see the isoquant that represents 300 units.

In the adjoining diagram we find that all combinations a, b, c, d and e can produce 300 units of output. In order to produce 300 units firm with try to find out least cost combination. For this it will super impose the various iso-cost lines on isoquant as shown in the diagram. The diagram shows that combination ‘C’ is,the least cost combination as here isoquant is tangent to iso-cost line HI. All other combinations a, b, d and e lying on isoquant cost more as these points lie on higher iso-cost lines. Hence, the point of tangency of isoquant and iso-cost line shows least cost combination. At the point of tangency.

Slope of iso-quant = Slope of iso-cost line

Thus, the firm will choose OM units of factor X and ON units of factor Y and be at equilibrium as the marginal physical products of two factors are proportional to the factor prices.

CA Foundation Business Economics Study Material Chapter 3 Theory of Production and Cost – Law of Returns to Scale

Law of Returns to Scale

• The Law of Returns to Scale examines the production function i.e. the input – output relation in long run where increase in output can be achieved by varying the units of ALL FACTORS IN THE SAME PROPORTION.
• Thus, in long run all factors become variable.
• It means that in long run the scale of production and the size of the firm can be increased.

The law of returns to scale analyse the effects of scale on the level of output as-

1. Increasing Returns to Scale:
   • When the output increases by a greater proportion than the proportion increases in all the factor inputs, it is increasing returns to scale.
   • E.g. When all inputs are increased by 10% and output rises by 30%.
   • The reasons of increasing returns to scale are – internal and external economies of scale; indivisibility of fixed factors; improved organisation; division of labour and specialisation; better supervision and control; adequate supply of productive factors, etc.
2. Constant Returns to Scale:
   • When the output increases exactly in the same proportion as that of increase in all factor inputs, it is constant returns to scale.
   • E.g. – When all inputs are increased by 10% and output also rises by 10%.
   • The reason of constant returns to scale is that beyond a certain point, internal and external economies are NEUTRALISED by growing internal and external diseconomies.
3. Diminishing Returns to Scale:
   • When the output increases by a lesser proportion than the proportion increase in all the factor inputs, it is diminishing returns to scale.
   • E.g. When all inputs are increased by 20% but output rises by 10%.
   • The reason of diminishing returns to scale is increased internal and external diseconomies of production.
   • Internal diseconomies like difficulties in management, lack of supervision and control, delay in decision-making etc.
   • External diseconomies like insufficient transport system, high freights, high prices of raw materials, power cuts, etc.

The law of returns to scale can also be illustrated with the help of the following schedule and diagram.

Returns to Factor and Returns to Scale

	Returns to Factor	Returns to Scale
1. Meaning	Returns to factor refers to the various production sizes where one factor is variable and other factor of production are fixed. In other words, it examines production function when the output is increased by varying the quantity of one input. It examines the effect of CHANGE IN THE PROPORTIONS between inputs on output.	Returns to scale refers to the various production sizes where increase in output can be achieved by varying the units of ALL FACTORS in the SAME PROPORTIONS. It show the effects on output when all factor inputs are varied in the same proportion simultaneously.
2. Nature of Inputs	Quantities of some inputs are fixed while the quantities of other inputs vary. In other words, there are FIXED and VARIABLE factors of production.	Quantities of all inputs can be varied. In other words, all factors of production are VARIABLE.
3. Time Element	Returns to factor is called a SHORT RUN production function.	Returns to scale is called a LONG RUN production function.
4. Application	It does not apply where the factors must be used in fixed proportion to produce a commodity.	It does apply where the factors must be used in fixed proportions to produce a commodity.
5. Stages of Law	The law has three stages namely – (a)    Increasing Returns to factor, (b)   Diminishing Returns to Factor, & (c)   Negative Returns to factor ‘ Of the three stages, diminishing returns pre-dominate.	The law has three stages namely – (a)    Increasing Returns to Scale, (b)   Constant Returns to Scale, (c)   Diminishing Returns to Scale. All the three stages of return appear.
6. Causes of Operation	Increasing returns to factor is due to indivisibility of fixed factors and division of labour and specialisation. Diminishing returns is due to non- optimal factor proportion and imperfect substitutability of factors. Negative returns fall in the efficiency of fixed and variable factors.	Increasing returns to scale is due to increased internal and external economies. Constant returns to scale is due to the fact that internal and external economies are neutralised by growing internal and external diseconomies. Diminishing returns is due to internal and external diseconomies of scale.
7. Scale of Production	The scale of output is unchanged and the production plant or the size and efficiency of the firm remain constant. This is because, only one factor is variable and all other factors are fixed.	The scale of output can be increased and so the size of the firm too can be expanded. This is because all factors are variable and hence can be increased in the same proportion simultaneously.

CA Foundation Business Economics Study Material Chapter 3 Theory of Production and Cost – Law of Variable Proportions

Law of Variable Proportions

• The Law of Variable Proportions examines the production function i.e. the input-output relation in short run where one factor is variable and other factors of production are fixed.
• In other words, it examines production function when the output is increased by varying the quantity of one input.
• Thus, the law examines the effect of change in the proportions between fixed and variable factor inputs on output in three stages viz. Increasing returns, diminishing returns and negative returns.

Statement of the Law :-
“As the proportion of one factor in a combination of factors is increased, after a point first the marginal and then the average product of that factor will diminish”. (F. Benhan)

The law operates under some assumptions which are as follows:-

1. There is only one factor which is variable. All other factors remain constant.
2. All units of variable factor are homogeneous
3. It is possible to change the proportions in which the various factors are combined.
4. The state of technology is given and is constant.

The three stages of the law can be explained with the help of the following schedule and diagram.

Stage I: The Law of Increasing Returns to Factor –

• During this stage, total product (TP) increases at an increasing rate upto the point of inflexion ‘I’ and thereafter it increases at diminishing rate.
• This is because marginal product (MP) of the variable factor increases upto point ‘M’ on MP curve and then start falling.
• Rising MP also pulls up average product (AP), which goes on rising, in the first stage.
• Rising AP indicates increase in the efficiency of variable factor i.e. labour.
• Stage I ends where AP is maximum and is equal to MP as shown by point ‘C’ in the diagram.

The law of increasing returns operates because of the following two reasons:

1. Indivisibility of fixed factors

• Due to indivisibility, the quantity of fixed factors is more than the quantity of variable factors.
• So when the quantity of variable factors is increased to work with fixed factors, output increases speedily due to full and effective utilisation of fixed factors.
• In other words, efficiency of fixed factors increases.

2. Efficiency of Variable Factor Increases
Due to increase in the quantity of variable factor, it becomes possible to introduce DIVISION OF LABOUR leading to SPECIALISATION. This results in more output per worker.

Stage II: The Law of Diminishing Returns to Factor –

• In second stage, TP continues to increase at diminishing rate. It reaches the maximum at point ‘D’ in the diagram, where the second stage ends.
• In this stage, both AP and MP of variable factor are falling- though remains positive. That is why this stage is called as the stage of diminishing returns.
• At the end of this stage MP becomes, zero as shown by point ‘B’ in the diagram and corresponding to highest point ‘D’ on TP curve.

The law of diminishing returns operate due to the following two reasons:

1. Indivisibility of fixed factors

• Once the optimum proportion between indivisible fixed factors and variable factors is reached (as in Stage I) with any further increase in the quantity of Variable factor, the fixed factors become inadequate and are overutilised.
• The fine balance between fixed and variable factor gets disturbed. This causes AP and MP to diminish.

2. Imperfect Substitutability of factors

• Variable factors are not perfect substitute of fixed factors.
• The elasticity of substitution between factors is not infinite.

Stage III: The Law of Negative Returns to Factor –

• In third stage, TP falls and so, TP curve slopes downward. MP becomes negative and the MP curve goes below the X-axis. AP continues to fall.
• As the MP of variable factor becomes negative, this stage is called the stage of negative returns.
• In this stage the efficiency of fixed and variable factors fall and factor ratio becomes highly sub-optimal.

The law of negative returns operate due to the following reasons:

1. The quantity of the variable factor becomes too excessive compared to fixed factors. They get in each other’s way and so TP falls and MP becomes negative.
2. Too large number of variable factors also reduce the efficiency of fixed factors.

Conclusion -Where to operate?

1. A rational firm will not produce either in Stage I or in Stage III.
2. In stage I, the marginal product of fixed factor is negative as its quantity is more than variable factor.
3. In stage III, the marginal product of variable factor is negative as its quantity is too large than fixed factor.
4. Therefore, firm would seek to produce in Stage II where both AP and MP of Variable factor are falling.
5. At which point to produce in this stage will depend on the prices of factor inputs.

CA Foundation Business Economics Study Material Chapter 3 Theory of Production and Cost – Meaning of Production

Meaning of Production

• Production is one of the important economic activity that takes place in any economy apart from consumption and investments.
• An individual firm is the micro-economic unit which undertake the production of goods and services.
• A firm’s survival depends upon whether it is able to achieve optimum efficiency in production by minimizing the cost of production.
• Production is the transformation of resources into goods and services. In other words, production is the act of transformation of INPUTS into OUTPUT which satisfies the wants of some people.
  E.g.- Inputs of sugarcane, capital and labour are used to produce SUGAR.
  Production also includes production of SERVICES like those of lawyers, teachers, doctors, etc.
• The amount of goods and services that an economy is able to produce determines whether it is rich or poor. A country like U.S.A. is a rich country as its production level is high.
• Man cannot create or destroy matter.
• In Economics, the term production means creation of economic utilities in the matter i.e. in the things that already exist.
• Thus, production means creation of those goods and services which have economic utilities i.e. exchange value.
• 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.”
• Professor J. R. Hicks has defined production “as any activity whether physical or mental, which is directed to the satisfaction of other people’s wants through exchange.”
• The definition indicates that the term production covers the whole process from creation of utilities till the satisfaction of human wants.

Utilities may be created or added in many ways, such as :-

1. Form Utility

• It is created by changing the form of raw materials into finished goods for man’s use.
• E.g. converting raw cotton into cotton fabric.
• Form utility is created by manufacturing industries.

2. Place Utility

• It is created by transporting goods from one place to another.
• E.g. when goods are taken from factory to marketplace, place utility is created.
• Transport services are involved in creation of place utility.

3. Time Utility

• It is created by making things available when they are required.
• E.g. Banks create time utility by granting overdraft facilities.

4. Service Utility (Personal Utility)

• It is created by providing personal services to the customers by professionals likes lawyers, doctors, bankers, shopkeepers, teachers, transporters, etc