chap 3 - me

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8/12/2019 Chap 3 - ME


Meaning of production

Important economic activity Performance of economy is judged by the level of its production

In Economics

A process by which man utilizes or converts the resources ofnature, working upon them so as to make them satisfy humanwants.

Any economic activity which is directed to the satisfaction of thewants of the people.

Therefore, manufacture of goods or rendering services are alsotermed as production.

E.g. water made drinkable, cotton made wearable, retailers,doctors, lawyers.

Production can also be defined as creation or addition ofutility – Not creation of matter

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The satisfying power of goods & services is called

utility.

Utilities can be created in different ways

A) Form utility– log into wood, iron into machine

B) Place utility – oil from Malaysia, apples

C) Time utility – preservation/storage

D) Possession utility – flat/house/office

E) Service utility – teachers/singers/musicians

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The relationship between the inputs and outputs of a

firm is referred as production function Also defined as the minimum quantities of various

inputs that are required to yield a given quantity ofoutput

Outputs– volume of goods or services

Inputs – factors of production

PF can be studied in short term or long term basis

Short period – too short for the firm to make changes

in equipments and therefore capital employed remainsfixed – Law of variable Proportion

Long period – all the factors of production are variable– Law of returns to scale

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A firm must decide how much to produce

Increase in scale of productions means increase in

output

Economies of large scale production– Advantages of

producing more.

Classified in to Internal and External economies of

scale

Internal Economies–Benefits observed within the

firm and its department

External Economies – Benefits observed as a result in

expansion of Industry as a whole.

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Technical economies

Economies of increased dimensions

Economies of linking of processes

Economies of Superior Technique Economies of specialization and Division of Labour

Managerial &Commercial Economies

Marketing Economies

Financial Economies

Risk-Bearing Economies

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Supervision & Management becomes difficult

Obstruction to work like Strike, Lockout, Disputes

increases

Product are standardized and thus personal touchwith consumer is many a times not possible

May cause overproduction and results into losses

Fight hard to maintain the market

Not flexible

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Encouraging competition

Over crowding of cities, traffic congestion,

pollution

Strain on whole Industrial System

Highlighted in the eyes of government & tax

department

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Land: refers to all free gifts of nature which would includebesides land, the natural resources.

Labor: mental or physical exertion directed to produce goods or services.

Anything done out of love & affection does not represent labor ineconomics.

E.g. wife & maid, singing

Capital: part of wealth of an Individual or community which is used for

further production of wealth

Produced means of production

E.g. machines, tools, dams, transport equipment.

Entrepreneur: is a factor which mobilizes above factors,combines in the right proportion, then initiates theproduction and bears the risk involved in it.

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Statement of the law:

“The law of variable proportions states that when more and more

units of the variable factor are added to a given quantity of fixed

factors, the total product may initially increase at an increasing rate reach the maximum and then decline”.

Assumptions

1. The law applies only in the short run.

2. One factor of production is variable & others are fixed.

3. All units of variable factor are homogeneous.

4. State of technology is given & remains the same.

5. Factor proportions can he changed.

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Key terms in production analysis

Total product (TP): The total amount of output

resulting from the efforts of given production function

at a given time

Average product(AP): Total product per unit of giveninput factor.

Marginal product(MP): The change in total product per

unit change in given input factor or the quantity ofvariable factor.

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Three Stages of Production in Short

RunAP,MP

X

Stage IStage II

Stage III

APX

MPXFixed input grosslyunderutilized;

specialization andteamwork causeAP to increasewhen additional Xis used

Specialization andteamwork continue to

result in greateroutput whenadditional X is used;fixed input beingproperly utilized

Fixed input capacityis reached;additional X causesoutput to fall

THE LAW OF DIMINISHING RETURNS &

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0

1

2

3

4

5

0 1 2 3 4 5 6 7

0

2

4

6

8

10

12

14

16

1 2 3 4 5 6 7 6

’

Total

Product

Marginal

&

Average

Product

Labor

Labor

THE LAW OF DIMINISHING RETURNS &

ST GES OF PRODUCTION

Stage I Stage II Stage III

TP

MP

AP

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Three stages of production

-Stage I: Increasing Returns –

TP increases atincreasing rate, indicated by increasing MP.

-There is intermediary constant stage between

stage I & stage II. TP increases at a constant rate

indicated by constant MP

-Stage II: Diminishing Returns – TP continues to

increase but at diminishing rates, indicated by

declining MP

-Stage III: Negative Returns – TP begins to decline,

indicated by negative MP

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1. When TP increases at increasing rate, MP also increases. 2. When TP starts increasing at decreasing rate, MP

decreases but remains positive 3. When TP is maximum & constant MP is O (zero) 4. When TP begins to fall, MP is negative• If MP is positive then TP is increasing.

• If MP is negative then TP is decreasing.

• TP reaches a maximum when MP=0 (MaximizationCondition!)

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Marginal and Average Product

When marginal product is greater than the average product,

the average product is increasing

When marginal product is less than the average product, the

average product is decreasing

When marginal product is zero, total product (output) is at

its maximum Marginal product crosses average product at its maximum

▫ If MP > AP then AP is rising.

▫

If MP < AP then AP is falling.

▫ MP=AP when AP is maximum

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Three stages of production

Total Product Marginal Product Average Product

STAGE I

Increases at an increasing

rate

Increases and reaches its

maximum

Increases (but slower than

MP)

STAGE II

Increases at a diminishing

rate and becomes

maximum

Starts diminishing and

becomes equal to zero

Starts diminishing

STAGE III

Reaches its maximum,

becomes constant and

then starts declining

Keeps on declining and

becomes negative

Continues to diminish

(but must always be

greater than zero)

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1. Increasing return to a factor:-

(i) Fuller utilization of fixed factor : In the initialstages Fixed factor remain under utilized its fuller

utilization starts with the more application of

variable factor, hence, initially additional unit of

variable factors add more to the total output

(ii) Specialization of Labour :- Additionalapplication of Variable factor causes process based

division of Labour that raises the efficiency offactors. Accordingly marginal productivity tends to

rise.

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2. Diminishing return to a factor:-

(i) Imperfect factor substitutability :- Factors of

production are imperfect substitutes of each other.More & more of Labour, for eg. Cannot be

continuously used in place of additional capital.

Accordingly diminishing returns to variable factor

becomes inevitable.

(ii) Disturbing the optimum proportion :-

Continuous increase in application of variable factor

along with fixed factors beyond a point crosses the

limit of ideal factor ratio. This results

in poor co-ordination between the fixed & variable

factors which causes diminishing return to a factor.

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3. Negative returns to a factor :-

(i) Overcrowding :- When more & more variable

factors are added to a given quantity of fixed

factor it will lead to over crowding & due to

this MP of the Labours decreases & it goes into

negative

(ii) Management Problems :- When there are toomany workers they may shift the responsibility to

others & it becomes difficult for the managementto coordinate with them. The Labours avoid doing

work. All these things lead to decrease in

efficiency of Laboures. Thus the output also

decreases.

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Production should be stopped at the point where

Marginal Product is equal to Marginal Cost

Here there is maximum utilization of resources

MP=MC= max utilization of resources.

Ideally it should beMP ≥ MC

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Production Function in Long Run

Laws of Returns to Scale

The percentage increase in output when all inputs vary

in the same proportion is known as returns to scale. It

obviously relates to greater use of inputs maintaining

the same technique of production.

Three Situations of Returns To Scale

- Increasing Returns to Scale - Constant Returns to Scale

- Decreasing Returns to Scale

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This law states that with

an increase in the quantity

of variable factor, average

and marginal productsshow a tendency to rise

(i.e. total product increases

with an increasing rate)

No

of

men

Total

Product

Average

Product

Marginal

Product

0 0 0 0

1 20 20 20

2 50 25 303 90 30 40

4 160 40 70

5 250 50 90

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This law explains that if the

quantity of a variable factor

is changed then the average

and marginal products will

not change i.e. total outputwill increase only at a

constant rate

This law is the intermediate

stage between the initialstage of the increasing return

and the ultimate stage of the

diminishing returns.

No

of

men

Total

Product

Average

Product

Marginal

Product

0 0 0 --1 100 100 100

2 200 100 100

3 300 100 100

4 400 100 100

5 500 100 100

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It is the ultimate stage of

production.

Initially an increase in the

quantity of variable factors

results in higher efficiency

and more production.

But beyond the optimum

stage increase in the variable

factors only disrupts the

existing organization andleads to inefficiency.

At this stage the average and

marginal products

continuously fall.

No

of

men

Total

Product

Average

Product

Marginal

Product

0 0 0 01 10 10 10

2 18 9 8

3 25 8.3 74 30 7.5 5

5 32 5.4 2

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Returns to Scale

Increasing returns to scale: output

more than doubles when all inputs are

doubled

Larger output associated with lower cost

(cars)

One firm is more efficient than many

(utilities)

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Higher degree of specializationCertain inputs cannot be divided into parts to suit small scaleproduction.

Technical and managerial indivisibilities

Use of specialized labour and modern machineryincreases productivity for variety of inputs.

Dimensional relations

Length and Breadth

15*10=150 sqft

30*20=600 sqft

The causes of increasing returns to

scale:

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Returns to Scale

Constant returns to scale: output

doubles when all inputs are doubled

Size does not affect productivity May have a large number of producers

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Returns to Scale

Decreasing returns to scale: output

less than doubles when all inputs are

doubled

Decreasing efficiency with large size

Reduction of entrepreneurial abilities

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Supply & Law of supply The concept supply occupies a signif icant place in economic

theory. Supply analysis is related to the behaviour of the producer –

supply of a commodity influenced by price of commodity.

In the ordinary language supply mean the stock of goods inexistence .

It is also mean the amount of good offered for sale per unit oftime .

In economics, supply mean during a given period of timequantities of goods which are offered for sale at particularprices.

Thus, supply of a commodity may be defined as the amount of thecommodity which the sellers are able & wil l ing to offer for sale ata particular period a given period of time .

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Thus, supply is always at a price & in relation to a period of time.

The higher the price, the greater will be the quantityof a commodity that will be supplied by a producer &vice – versa.

Therefore, the relationship between price & quantitysupplied is direct and positive.

Factors influences supply The quantity supplied of a commodity is not

dependent upon its price alone but on a number offactors such as –

Price of other commodities The prices of factors used in its production

The goal of producers &

The state of technology

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These factors can be written in the form of an

equation known as the supply function

(supply function)

Sq = f (pq, Pa, Pb…..F1, F2 … G, T)

Sq = Supply of commodity q

f = Functional relationship betweenprice of commodity & quantity supply

Pq = Price of commodity q

Pa Pb = Prices of other commodities

F1 , F2 = Prices of factors of production

G = Goal of producers

T = State of technology

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1. Price of the commodity

higher the price of commodity the larger

will be the quantity supplied and vice-versa.2. Prices of other commodities

A change in the price of other commodity

also affects the supply of commodity

For instance, if the price of good A rises, the

producer of good B may produce less of

good B & switch over to the production ofgood A in order to sell more of it.

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3. Price of factors

If the price of any one factor of production (labour &capital) used in the production of a commodity increases, it

cost of production will increase. As a result, its output will falls & the supply will be

reduced.

The reverse will happened in the case of fall in the price ofa factor.

4. Goals of Producers

If a producer aims at maximising profit, he will produceless of the commodity which involves large risk.

A producer who aims at maximising his sales will produce

& sell more.

5. State of Technology

If new & improved methods of production are used, theytend to increase the supply of commodities.

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The Law of Supply

Supply of a commodity is functionally related to its

price. The law of supply relates to this functional

relationship between price of a commodity & its

supply.

That is, higher the price, higher will be quantitysupplied & lower the prices lower will be quantity

supplied.

The law of supply can be stated that“other

thingsremaining the same, as the price of a commodity

rises, its supply is extended and as the price falls,

its supply is contracted.

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The quantity offered for sale directly varies withprice – higher the price, larger is the supply and

vice-versa.Supply Schedule

Supply schedule is a statement of variousquantities of given commodity offered for sale at

various per unit of time. A supply schedule may be individual supply

schedule or market supply schedule.

Individual supply schedule is a list of prices &

quantities that an individual is willing to produce& sell.

Whereas the market supply schedule is thesum total of individual supply schedules.

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Supply Schedule

Individual Supply

Schedule

Market Supply

Schedule

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Individual Supply Schedule

Prices (per dozen) in Rs Quantities of supplied

4 300

6 4008 500

10 600

12 700

14 900

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S

S

Quantities of Supplied

P r i c e s

300 600 900 1,200

8

6

4

2

B X

Y

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Market Supply Schedule of Product

Price ( inRs.)

Commodity is identical Aggregate

of A, B,and CA Firm B Firm C Firm

2 000 000 000 000

4 300 400 50 750

6 400 200 200 900

8 500 400 300 1200

10 600 500 400 1500

12 700 600 500 1800

14 900 800 750 2450

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Assumptions of the Law of the Supply

The number of firms in the market remains the same.

The scale of production do not change. Market prices of related goods remains constant over a

period of time.

Cost of Production does not change. Climatic conditions remains constant.

Taste and preferences of consumers remains constant.

Government polices such as taxation policy, trade

policy should be unchanged.

No changes in transport costs

No. other inputs are available in the market.

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Feature of the Law of Supply

1. There is a direct relationship between

quantity supplied and price.2. There are two variables – price and supply –

supply is the dependent variable and price

is an independent variable.3. This law is not universal in nature – it is

based on certain assumptions – other things

remaining constant.

4. Supply curve usually slopes upward from

left to r ight.

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Factors DeterminingSupply

Price TimePrices of related

commodities

Cost ofProduction Technology

NaturalFactors

Govt Policy & Action

FutureExpectations

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1. Price of the commodity

Higher the price of a commodity larger will be

the quantity supply and vice – versa. Higher prices always brings profit to producers.

2. Prices of related commodities

A change in the price of another commodity alsoaffects the supply of a commodity.

For instance, if the price of good A rises, the

producer of good B may produce less of good B

and switch over to the production of good A inorder to sell more to make an profit.

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3. Prices of factors of production

If price of factors of production increases – (labour

and capital) – cost of production increases andoutput will decline.

The reverse will happen in the case of a fall in the price of a factor.

4. Goal of Producers If a producer aims at maximising profit, he will

produces less of commodity and will involve largerisks.

A producer who aims at maximizing his sales will produce and sell more.

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5. State of Technology

If new and improved methods of production are

used – they tend to increase the supply ofcommodities.

6. Number of firms and sellers existence

Supply in a market depends on the no. of

firms/sellers producing and selling in the market.

When producer/sellers are few – supply will be

small and vice – versa.

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7. Cost of Production

The cost of production is an important item

affecting the supply. Wages, rate of interest, price of machinery

and equipment, raw-material etc influenceson cost of production.

8. Future Expectation

Seller sells the commodity or supplies on the basisof the prevailing prices.

If he feels that future prices will be higher, he willreduce the present supply of the product.

If he feels that future prices may fall he will betempted to sell more at the current prices.

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9. Natural factors

It is assumed that there is no change in natural factors

such as rain, drought etc – Agro Industries. Monsoon failure may result in the reducing of power

generation and eventually lead to curtailment of production.

10. Change in Government Policy Any change in govt policy will affect the supply.

A fresh tax or levy of excise duties on commoditywill affect the price of the commodity and as a resultthe supply will get affected.

An increase in tax will reduce the supply and grantingof subsidy and incentive will increase the supply.

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Elasticity of Supply

Supply change due to change in price

The extent of change in supply in accordance

with the change in price is called elasticity of

supply.

When, with a little change in price (rise/fall)

there is a considerable change in supply

(rise/fall).

The elasticity of supply is the degree of

responsiveness of a change in supply to a

change in price on the part of sellers.

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Elasticity of Supply

Es = Percentage Change in Quantity Supply

Percentage Change in Price

=Change in Quantity Supply

Change in price Initially

÷Change in Price

Initial supply

=∆Qs

Qs*∆P

P

Where

∆Qs = Change in Quantity Supply

∆P = Change in Price

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Types of Elasticity of Supply

1. Perfectly elastic supply

2. Perfectly inelastic supply

3. Unitary elastic supply

4. Relatively more elastic supply

5. Relatively less elastic supply

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1. Perfectly elastic supply When a small change in price lead to an infinitely large change

in the quantity supplied. Es =∞

Quantities of Supplied

P r i c e

P

O X

Y

SS

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2. Perfectly inelastic supply

When a change in price causes no change in

supply whatsoever. Es = 0

S

S

O X

Y

P

P1

P2

M

P

r i c e

Quantity of Supplied

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3. Unit elasticity of supply

The change in quantity of supply is exactly equal to

the change in price. When both are equal the elasticity is said to be

unitary. Es = 1

P r i c e s

Quantity of supply

P

P1

M M1O X

Y

S

S

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4. Relatively more elastic supply

It refers to that situation where a proportionate change in the

quantity of supply is much greater than the proportionate

change in price.

In other words, it refers to that situation where a small

proportionate fall in price of a commodities is followed by a

large proportionate increase in its quantity supply and vice

versa. Es > 1.

S

S

P

P1

O

Y

X

Quantity Supply

M M1

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5. Relatively less elastic Supply

It refers to that situation where the proportionate change in the

quantity of supply is much less than the proportionate change

in price.

In other words, it refers to that situation where a great

proportionate fall in price of a commodities followed by a

small proportionate changes in quantity supply.

Es < 1.

P

P1

M M1

Y

XO

S

S

P r i c e

Quantity Supply

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Table - Types of Price Elasticity of Supply

Sl No. Types of

ES

Numerical

Expression

Description Shape of

Curves

1. Perfectly

Elastic

∞ Infinite Horizontal

2. PerfectlyInelastic

0 Zero Vertical

3. Unit Elastic 1 One Rectangular

Hyperbola

4. RelativelyElastic

> 1 More thanOne

Flat

5. Relatively

Inelastic

< 1 Less than

One

Steep

T f El i i f S l

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Types of Elasticity of Supply

S1

S2

S3

S4

S5

S

Quantity of Supply

Price

S5 = 0

S1 = < 1

S3 = 1

S2

= > 1

S4 = ∞

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