BUSINESS ECONOMICS

UNIT 4 PRODUCTION ANALYSIS

Introduction
Production is an important economic activity which satisfies the wants and needs of the
people. Production refers to conversion of raw material into finished goods. Or conversion of
input into output. Production function brings out the relationship between inputs used and the
resulting output. A firm is an entity that combines and processes resources in order to produce
output that will satisfy the consumer’s needs. The firm has to decide as to how much to produce
and how much input factors (labour and capital) to employ to produce efficiently.
Factors of production include resource inputs used to produce goods and services.
Economist categorise input factors into four major categories such as land, labour, capital and
organization.
 Land: Land is heterogeneous in nature. The supply of land is fixed and it is a permanent
factor of production but it is productive only with the application of capital and labour.
 Labour: The supply of labour is inelastic in nature but it differs in productivity and efficiency
and it can be improved.
 Capital: is a manmade factor and is mobile but the supply is elastic.
 Organization: the organization plans, supervises, organizes and controls the business
activity and also takes risks.

The Cost of Production is also called production costs or cost price. It is the total cost
sustained by a business to produce a specific quantity of a product. It includes all direct and
indirect costs of manufacturing the product. The cost of production includes various direct and
indirect costs that come in between the process of manufacturing.
 Explicit cost- An explicit cost is a cost that is directly incurred by the firm, company or
organization during the production. The explicit cost is kept on record by the accountant of
the firm. Salaries, wages, rent, raw material are example of the explicit cost. The explicit cost
is also known as out- pocket cost. This cost is handy in calculating both accounting and
economic profit.
 Implicit cost- The implicit cost is directly opposite to it, as it is the cost that is not directly
incurred by the firm or company. In implicit cost outflow of cash doesn’t take place. It is not
in the record and is he ard to be traced back. The interest on owner’s capital or the salary of
the owner is the prominent example of the implicit cost. The implicit cost is also known as
imputed cost. Through implicit cost only the economic profit is calculated.

Basic Terms
 An input is a good or service that goes into the production process. As economists refer to it,
an input is simply anything which a firm buy for use in its production process. Inputs are
considered variable or fixed depending on how readily their usage can be changed
 An output, on the other hand, is any good or service that comes out of a production process.
 Fixed input – An input for which the level of usage cannot readily be changed
 In economic sense, a fixed input is one whose supply is inelastic in the short run.
 In technical sense, a fixed input is one that remains fixed (or constant) for certain level of
output.
 Variable input- A variable input is one whose supply in the short run is elastic, example,
labour, raw materials, and the like. Users of such inputs can employ a larger quantity in the
short run.
Technically, a variable input is one that changes with changes in output. In the long run, all
inputs are variable.
 Short run – At least one input is fixed. All changes in output achieved by changing usage
of variable inputs.
 Long run – All inputs are variable. Output changed by varying usage of all inputs
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Production Function
A tool of analysis used in explaining the input-output relationship. It describes the
technical relationship between inputs and output in physical terms. In its general form, it holds
that production of a given commodity depends on certain specific inputs.
In its specific form, it presents the quantitative relationships between inputs and outputs. A
production function may take the form of a schedule, a graph line or a curve, an algebraic
equation or a mathematical model. The production function represents the technology of a firm.
An empirical production function is generally so complex to include a wide range of inputs: land,
labour, capital, raw materials, time, and technology. These variables form the independent
variables in a firm’s actual production function. A firm’s long-run production function is of the
form:
Q = f (Ld, L, K, M, T, t)
Where,
Ld = land and building
L = labour
K = capital
M = materials
T = technology and, t = time
For sake of convenience, economists have reduced the number of variables used in a
production function to only two: capital (K) and labour (L). Therefore, in the analysis of input -
output relations, the production function is expressed as:
Q = f (K, L)
Increasing production, Q, will require K and L, and whether the firm can increase both K and L
or only L will depend on the time period it takes into account for increasing production, that is,
whether the firm is thinking in terms of the short run or in terms of the long run.
Economists believe that the supply of capital (K) is inelastic in the short run and elastic in the
long run. Thus, in the short run firms can increase production only by increasing labour, since
the supply of capital is fixed in the short run. In the long run, the firm can employ more of both
capital and labour, as the supply of capital becomes elastic over time.

Measures of Productivity
 Total production (TP): the maximum level of output that can be produced with a given
amount of input.
 Average Production (AP): output produced per unit of input AP = Q/L
 Marginal Production (MP): the change in total output produced by the last unit of an input
 Marginal production of labour = Δ Q / Δ L (i.e. change in the quantity produced to a gi ven
change in the labour)
 Marginal production of capital = Δ Q / Δ K (i.e. change in the quantity produced t o a given
change in the capital

Total Production, Marginal Production, and Average Production

Labour TP MPL APL

0 0 – –
1 10 10 10
2 24 14 12
3 40 16 13.33
4 50 10 12.5
5 56 6 11.2
6 57 1 9.5
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60 56 57

50
50
Measures of Production

40
40

30
24

20 16
14 12.5 11.2
10 9.5
10 12 13.33 10
0 6
0 1
0 1 2 3 4 5 6
Labour Units

TP MPL APL

Returns to a Factor
Commonly referred to as factor productivity, the returns to a factor can be described as the
short-term relationship between the output and the input. The productivity generated from one
production unit will be the same as the output generated. The factor’s productivity is calculated
with an assumption that all other factors remain unchanged.
The returns to factor are related to the overall behaviour of the total output as only one variable
input. Generally, the returns to a factor is a short-term concept. It further consists of three major
factors –
 Constant returns to a factor
 Increasing returns to a factor
 Diminishing returns to a factor.

The change in productivity can result into –

 Total productivity – The total physical product, also known as the total productivity, can be
referred to as the total output generated at the input’s varied levels of a particular factor.
 Marginal productivity – The marginal physical product or the marginal productivity is referred
to as an additional output generated by adding more units of factor while keeping all other
factors untouched or constant.

Law of Returns to Scale (Long Run)

 “The term returns to scale refers to the changes in output as all factors change by the same
proportion.” Koutsoyiannis
 “Returns to scale relates to the behaviour of total output as all inputs are varied and is a long
run concept”. Leibhafsky

Returns to scale are of the following three types:

1. Increasing Returns to scale.
2. Constant Returns to Scale
3. Diminishing Returns to Scale

Explanation:
In the long run, output can be increased by increasing all factors in the same proportion.
Generally, laws of returns to scale refer to an increase in output due to increase in all factors in
the same proportion. Such an increase is called returns to scale.
The law of returns to scale describes the relationship between variable inputs and output when
all the inputs, or factors are increased in the same proportion. The law of returns to scale
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analysis the effects of scale on the level of output. He re we find out in what proportions the
output changes when there is proportionate change in the quantities of all inputs.
It has been observed that when there is a proportionate change in the amounts of inputs, the
behaviour of output varies. The output may increase by a great proportion, by in the same
proportion or in a smaller proportion to its inputs. This behaviour of output with the increase in
scale of operation is termed as increasing returns to scale, constant returns to scale and
diminishing returns to scale.
 Increasing Returns to Scale:
If the output of a firm increases more than in proportion to an equal percentage increase in all
inputs, the production is said to exhibit increasing returns to scale.
For example,
If the amount of inputs is doubled and the output increases by more than double, it is said to be
an increasing return to scale. When there is an increase in the scale of production, it leads to
lower average cost per unit produced as the firm enjoys economies of scale .
 Constant Returns to Scale:
When all inputs are increased by a certain percentage, the output increases by the same
percentage, the production function is said to exhibit constant returns to scale.
For example,
If a firm doubles inputs, it doubles output. In case, it triples output. The constant scale of
production has no effect on average cost per unit produced.
 Diminishing Returns to Scale:
The term 'diminishing' returns to scale refers to scale where output increases in a smaller
proportion than the increase in all inputs.
For example,
If a firm increases inputs by 100% but the output decreases by less than 100%, the firm issaid to
exhibit decreasing returns to scale. In case of decreasing returns to scale, the firm faces
diseconomies of scale. The firm's scale of production leads to higher average cost per unit
produced

Law of Variable Proportions or Law of Diminishing Returns (Short Run)

Law of Variable Proportions occupies an important place in economic theory. This law is
also known as Law of Proportionality. This law exhibits the short -run production functions in
which one factor varies while the others are fixed. Also, when you obtain extra output on
applying an extra unit of the input, then this output is either equal to or less than the output
that you obtain from the previous unit.
The Law of Variable Proportions concerns itself with the way the output changes when you
increase the number of units of a variable factor. Hence, it refers to the effect of the changing
factor-ratio on the output.
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In other words, the law exhibits the relationship between the units of a variable factor a nd
the amount of output in the short-term. This is assuming that all other factors are constant. This
relationship is also called returns to a variable factor.
The law states that keeping other factors constant, when you increase the variable factor,
then the total product initially increases at an increases rate, then increases at a diminishing
rate, and eventually starts declining.

Definitions:
 “As the proportion of the factor in a combination of factors is increased after a point, first the
marginal and then the average product of that factor will diminish.” Benham
 “An increase in some inputs relative to other fixed inputs will in a given state of technology
cause output to increase, but after a point the extra output resulting from the same additions
of extra inputs will become less and less.” Samuelson
 “The law of variable proportion states that if the inputs of one resource is increased by equal
increment per unit of time while the inputs of other resources are held constant, total output
will increase, but beyond some point the resulting output increases will become smaller and
smaller.” Leftwitch
 Marshall discussed the law of diminishing returns in relation to agriculture. He defines the
law as follows: “An increase in the capital and labour applied i n the cultivation of land causes
in general a less than proportionate increase in the amount of product raised unless it
happens to coincide with improvement in the arts of agriculture.”

Assumptions in the Law of Variable Proportions

The law of variable proportions is based on these following assumptions –
 Constant Technology: It is assumed that the state of technology is constant and is not
improving or degrading during alterations of production variables. If there is an improvement
or degradation in the technology adopted by a company for its production unit, it will be
impossible to get a clear understanding how a change in the production variables is affecting
the overall output.
 Variable Factors: As per this law, production factors are assumed to be variable. If all
production variables are considered as a fixed proportion in relation to the output, this will be
invalid.
 Homogenous Units: All the units of the variable factor are regarded as homogenous. This
indicates that each and every unit is of identical quality and quantity and amount to an
identical figure.
 Short-Run: The law of variable proportions only works for systems operating short -term
where it is not feasible to alter every production input.

Let’s understand this law with the help of another example:

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In the above table,
 Land is considered as fixed factor and labour is variable factor of production.
 As the labour are increased keeping land fixed, TP first increases that the increasing rate up
to the 3rd unit of labour and increases at a diminishing rate up to the 5 th unit of labour. TP
is maximum at the 5th unit of labour and becomes stable up to the 6th units of labour and
starts to fall.
 MP first increases i.e., become maximum at the 3rd unit of labour and thereafter decline.
 MP is zero at 6th units of labour and thereafter negative.
 AP also increases at first, becomes maximum at the 3rd unit of labour and stable upto 4th
unit of labour, there after declines.
 AP and MP are equal at the 4th unit of labour.
 Though AP declines it never becomes zero.

In this example, the land is the fixed factor and labour is the variable factor. The table shows
how different amounts of output when you apply different units of labour to one acre of land
which need fixing.
The following diagram explains the law of variable proportions. In order to make a simple
presentation, we draw a Total Physical Product (TPP) curve and a Marginal Physical Product
(MPP) curve as smooth curves against the variable input (labour).

Three Stages of the Law

The law has three stages as explained below:
1. Stage I – The TPP increases at an increasing rate and the MPP increases too. The MPP
increases with an increase in the units of the variable factor. Therefore, it is also called the
stage of increasing returns. In this example, the Stage I of the law runs up to thr ee units of
labour (between the points O and L).
Cause of increasing returns in the first stage
 Increase in efficiency of fixed factor-In this stage of production, the quantity of fixed
factor is abundant relative to the variable factor. When more variable factors are
employed, the fixed factor is more efficiently utilized. As such, increasing returns are
achieved.
 Increase in the efficiency of variable factor - Due to additional units of variable factors
employed, at the beginning the efficiency of productive capacity of variable factor itself
increases. It is due to division of labour or specialization which helps to obtain higher
productivity.
2. Stage II – The TPP continues to increase but at a diminishing rate. However, the increase is
positive. Further, the MPP decreases with an increase in the number of units of the variable
factor. Hence, it is called the stage of diminishing returns. In this example, Stage II runs
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between four to six units of labour (between the points L and M). This stage reaches a point
where TPP is maximum (18 in the above example) and MPP becomes zero (point R).
Causes of decreasing returns
 Scarcity of fixed factors - In short-run amount of fixed factor cannot be changed. Fixed
factor becomes inadequate relative to the quantity of the variable factor. This result is
decreasing returns.
 Indivisibility of fixed factor - Once the optimum proportion between fixed factor and
variable factors is disturbed by further increase in the variable factor, indivisible factor is
being used in wrong proportion with variable factor. So, the average product of variable
factor diminishes which depicts diminishing returns.
 Imperfect substitutability of the factor - Fixed factor is inadequate relatively to the
variable factor whose quantity cannot be increased in accordance with the varying
quantities of the other factors. This results diminishing returns.
3. Stage III – Now, the TPP starts declining, MPP decreases and becomes negative. Therefore, it
is called the stage of negative returns. In this example, Stage III runs between seven to eight
units of labour (from the point M onwards).
Causes of negative returns
 Inefficient utilization of variable factors
 Over utilization of fixed factors
 Complexity of management

Applicability of the Law of Variable Proportions:

The law of variable proportions is universal as it applies to all fields of production. This
law applies to any field of production where some factors are fixed and others are variable. That
is why it is called the law of universal application.
The main cause of application of this law is the fixity of any one factor. Land, mines,
fisheries, and house building etc. are not the only examples of fixed factors. Machines, raw
materials may also become fixed in the short period. Therefore, this law holds well in all activities
of production etc. agriculture, mining, manufacturing industries.
1. Application to Agriculture: With a view of raising agricultural production, labour and
capital can be increased to any extent but not the land, being fixed factor. Thus when more
and more units of variable factors like labour and capital are applied to a fixed factor then
their marginal product starts to diminish and this law becomes operative.
2. Application to Industries: In order to increase production of manufactured goods, factors of
production has to be increased. It can be increased as desired for a long period, being
variable factors. Thus, law of increasing returns operates in industries for a long period. But,
this situation arises when additional units of labour, capital and enterprise are of inferior
quality or are available at higher cost.
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As a result, after a point, marginal product increases less proportionately than increase in the
units of labour and capital. In this way, the law is equally valid in industries.

Iso-Cost Line
An Isocost line is defined as the locus of factor combinations that can be purchased for a given
total cost. It is also called the Price line or Outlay line. The iso cost line plays an important part
in determining what combination of factors the firm will choose for production. An Isocost line in
Figure 2 shows various combinations of two factors that the firm can buy with a given outlay. Iso
cost line depends upon two things, viz., prices of the factors of production and the total outlay
which thefirm has to make on the factors.
Let us assume that the firm has Rs 100 to spend on two factors K and L. The price of
factor K is Rs 20 per unit and the price of factor L is Rs 10 per unit.
Combinations Capital K (1=Rs20) Labour L (1=Rs10) Total Cost
A 0 10 0*20+10*10= Rs100
B 1 8 1*20+8*10= Rs100
C 2 6 2*20+6*10= Rs100
D 3 4 3*20+4*10= Rs100
E 4 2 4*20+2*10= Rs100
F 5 0 5*20+0*10= Rs100

In the above diagram, AF is the Iso Cost line. Combination A contains 10 units of labour and
Zero units of capital. Similarly, B contains 8 units of labour and 1 unit of capital. Likewise,
combinations C, D, E and F contains, 6L+2K, 4L+3K, 2L+4K and 0L+5K. Any combination
outside the iso-cost line is not attainable because of insufficient total cost outlay. Similarly, any
combination inside the iso-cost line is not desirable because some of the budget remain idle.

Isoquants
The Greek word ‘iso’ means ‘equal’ or ‘same’ and ‘quant’ is the short form of quantity.
Thus an isoquant is a curve along which output is the same. For the sake of analysis, we are
assuming that a producer employs two inputs—labour (L) and capital (K).
A firm can produce a certain amount of a commodity by employing different combi-nations
of labour and capital. When this information is plotted on a graph paper, we obtain an isoquant.

Isoquant Curve
It is a locus of various combinations of two factors of production giving the same level of output
and a producer is indifferent to each of such combinations. All the combinations of two inputs
give the same quantum of output to a producer and the producer is indifferent to each such
combination. He does not have any preference. These isoquant curve also known as production
indifference curves.
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Assumptions
1. Two Factors of Production: Only two factors are used to produce a commodity.
2. Divisible Factor: Factors of production can be divided into small parts.
3. Constant Technique: Technique of production is constant or is known beforehand.
4. Possibility of Technical Substitution: The substitution between the two factors is
technically possible. That is, production function is of “variable proportion” type rather than
fixed proportion.
5. Efficient Combinations: Under the given technique, factors of production can be used with
maximum efficiency.

The concept of iso-quant can be explained with the help of iso-quant schedule and diagram
Combination Factor A (Labour) Factor B (Capital) Output
A 1 5 100
B 2 4 100
C 3 3 100
D 4 2 100
E 5 1 100

The above schedule shows the different combinations of two inputs, namely labour and capital,
the resultant output 100 units from each combination. The units of labour are increasing and
units of capital are decreasing but the quantity of output remains the same.

Properties of Isoquants
1. Isoquants are downward sloping from left to right - Isoquant have a negative slope
because if a firm wants to employ more units of one factor, than it has to reduce the units of
other factor to produce same level of output. It is assumed that marginal product of the
factors is positive i.e. increase in the quantity of factor leads to positive increase in the
output. Thus if the amount of one factor is increases, the amount of other factor has to be
decrease to produce the same level of output. There are certain inconsistencies follow if the
isoquants do not have a negative slope.
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2. Isoquants are convex to the origin - This feature of isoquants is based upon the ‘Principle
of Diminishing Marginal Rate of Technical Substitution’. The slope of an isoquant is known as
marginal rate of technical substitution. It is defined as the quantity of capital (K) that a firm
is willing to sacrifice for an additional quantity of labour (L) to keep the same level of output.
Along downward sloping isoquant, marginal productivity of labour decreases with the
increase in units of labour and simultaneously marginal productivities of capital increase
with the reduction in the units of capital. Thus, lesser amount of capital is required to keep
the output constant.

3. Two Isoquants never intersect or touch each other - We prove this property by
contradiction. If two isoquants IQ1&IQ2 intersect each other at point ‘e’. Point e shows that
same combination of capital &labour can produce two different level of output. However, it is
not possible that one combination of factor can produce two different level of output. This is
illogical and absurd. Thus, isoquants never intersect each other

4. Higher isoquant represents a higher level of output- A higher isoquant indicates a higher
level of output produced by a firm. Isoquants represent different combinations of inputs that
yield the same level of output. When an isoquant shifts outward or upwards, it signifies that
more output can be produced using the same inputs, reflecting increased productivity or
efficiency.
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5. An isoquant curve should not touch the X or Y axis on the graph- In the production
process, both capital and labour inputs are necessary to generate an output. If an isoquant
curve touches either the X or Y axis, it would imply that one of the inputs (either labour or
capital) is zero, which is impossible. This violates the basic principle that both inputs need to
be present in proportion to generate the desired output.

6. Isoquant curves do not have to be parallel to each other-The shape of an isoquant curve
depends on the MRTS. Since the substitution rate between labour and capital can vary in
different isoquant schedules, the curves do not have to be parallel to each other.

7. Isoquant curves are oval-shaped – The isoquant curve represents the efficiency of using
inputs. Its oval shape allows firms to identify the production efficiency by using an optimal
mix of capital and labour inputs.
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ECONOMIES OF SCALE
Production may be carried on a small scale or o a large scale by a fi rm. When a firm
expands its size of production by increasing all the factors, it secures certain advantages known
as economies of production. Marshall has classified these economies of large -scale production
into internal economies and external economies.
1. Internal economies are those, which are opened to a single factory or a single firm
independently of the action of other firms. They result from an increase in the scale of output
of a firm and cannot be achieved unless output increases. Hence internal economies depend
solely upon the size of the firm and are different for different firms.
2. External economies are those benefits, which are shared in by a number of firms or
industries when the scale of production in an industry or groups of industries increases.
Hence external economies benefit all firms within the industry as the size of the industry
expands.

1. Internal Economies: Internal economies may be of the following types.

 Technical Economies: Technical economies arise to a firm from the use of better machines
and superior techniques of production. As a result, production increases and per unit cost of
production falls. A large firm, which employs costly and superior plant and equipment,
enjoys a technical superiority over a small firm. Another technical economy lies in the
mechanical advantage of using large machines. The cost of operating large machines i s less
than that of operating mall machine. More over a larger firm is able to reduce it s per unit cost
of production by linking the various processes of production. Technical economies may also
be associated when the large firm is able to utilize all its waste materials for the development
of by-products industry. Scope for specialization is also available in a large firm. This
increases the productive capacity of the firm and reduces the unit cost of production.
 Managerial Economies: These economies arise due to better and more elaborate
management, which only the large size firms can afford. There may be a separate head for
manufacturing, assembling, packing, marketing, general administration etc. Each
department is under the charge of an expert. Hence the appointment of experts, division of
administration into several departments, functional specialization and scientific co-
ordination of various works make the management of the firm most efficient.
 Marketing Economies: The large firm reaps marketing or commercial economies in buying
its requirements and in selling its final products. The large firm generally has a separate
marketing department. It can buy and sell on behalf of the firm, when the market trends are
more favourable. In the matter of buying they could enjoy advantages like preferential
treatment, transport concessions, cheap credit, prompt delivery and fine relation with
dealers. Similarly, it sells its products more effectively for a higher margin of profit.
 Financial Economies: The large firm is able to secure the necessary finances either for
block capital purposes or for working capital needs more easily and cheaply. It can barrow
from the public, banks and other financial institutions at relatively cheaper rates. It is in this
way that a large firm reaps financial economies.
 Risk bearing Economies: The large firm produces many commodities and serves wider
areas. It is, therefore, able to absorb any shock for its existence. For example, during
business depression, the prices fall for every firm. There is also a possibility for market
fluctuations in a particular product of the firm. Under such circumstances the risk-bearing
economies or survival economies help the bigger firm to survive business crisis.
 Economies of Research: A large firm possesses larger resources and can establish it‟s own
research laboratory and employ trained research workers. The firm may even invent new
production techniques for increasing its output and reducing cost.
 Economies of welfare: A large firm can provide better working conditions in-and out-side
the factory. Facilities like subsidized canteens, crèches for the infants, recreation room,
cheap houses, educational and medical facilities tend to increase the productive efficiency of
the workers, which helps in raising production and reducing costs.
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2. External Economies: Business firm enjoys a number of external economies, which are
discussed below:
 Economies of Concentration: When an industry is concentrated in a particular area, all
the member firms reap some common economies like skilled labour, improved means of
transport and communications, banking and financial services, supply of power and
benefits from subsidiaries. All these facilities tend to lower the unit cost of production of all
the firms in the industry.
 Economies of Information: The industry can set up an information centre which may
publish a journal and pass on information regarding the availability of raw materials,
modern machines, export potentialities and provide other information needed by the firms.
It will benefit all firms and reduction in their costs.
 Economies of Welfare: An industry is in a better position to provide welfare facilities to the
workers. It may get land at concessional rates and procure special facilities from the local
bodies for setting up housing colonies for the workers. It may also establish public health
care units, educational institutions both general and technical so that a continuous supply
of skilled labour is available to the industry. This will help the efficiency of the workers.
 Economies of Disintegration: The firms in an industry may also reap the economies of
specialization. When an industry expands, it becomes possible to spilt up some of the
processes which are taken over by specialist firms. For example, in the cotton textile
industry, some firms may specialize in manufacturing thread, others in printing, still others
in dyeing, some in long cloth, some in dhotis, some in shirting etc. As a result, the efficiency
of the firms specializing in different fields increases and the unit cost of production falls.
Thus internal economies depend upon the size of the firm and external economies depend upon
the size of the industry.

DISECONOMIES OF SCALE
Internal and external diseconomies are the limits to large -scale production. It is possible
that expansion of a firm’s output may lead to rise in costs and thus result diseconomies instead
of economies. When a firm expands beyond proper limits, it is beyond the capacity of the
manager to manage it efficiently. This is an example of an internal diseconomy. In the same
manner, the expansion of an industry may result in diseconomies, which may be called external
diseconomies. Employment of additional factors of production becomes less efficient and they are
obtained at a higher cost. It is in this way that external diseconomies result as an industry
expands.

The major diseconomies of large -scale production are discussed below:

1. Internal Diseconomies
 Financial Diseconomies: For expanding business, the entrepreneur needs finance. But
finance may not be easily available in the required amount at the appropriate time. Lack of
finance retards the production plans thereby increasing costs of the firm.
 Managerial diseconomies: There are difficulties of large -scale management. Supervision
becomes a difficult job. Workers do not work efficiently, wastages arise, decision -making
becomes difficult, coordination between workers and management disappears and
production costs increase.
 Marketing Diseconomies: As business is expanded, prices of the factors of production will
rise. The cost will therefore rise. Raw materials may not be available in sufficient quantities
due to their scarcities. Additional output may depress the price in the market. The demand
for the products may fall as a result of changes in tastes and preferences of the people.
Hence cost will exceed the revenue.
 Technical Diseconomies: There is a limit to the division of labour and splitting down of
production p0rocesses. The firm may fail to operate its plant to its maximum ca pacity. As a
result, cost per unit increases. Internal diseconomies follow.
 Diseconomies of Risk-taking: As the scale of production of a firm expands risks also
increase with it. Wrong decision by the management may adversely affect production. In
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large firms are affected by any disaster, natural or human, the economy will be put to
strains.
2. External Diseconomies
When many firm get located at a particular place, the costs of transportation increases due to
congestion. The firms have to face considerable delays in getting raw materials and sending
finished products to the marketing centres. The localization of industries may lead to scarcity
of raw material, shortage of various factors of production like labour and capital, shortage of
power, finance and equipment’s. All such external diseconomies tend to raise cost per unit.

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MCQS
1. Which of the following is NOT a factor of production?
a. Goods b. Labour c. Capital d. Land

2. What is the relationship between inputs and output described by the production function?
a. Output depends only on labour
b. Output depends only on capital
c. Output depends on the combination of inputs
d. Output is independent of inputs

3. Which of the following is an example of an explicit cost?

a. Interest on owner's capital b. Rent
c. Salary of the owner d. Indirect costs

4. In the short run, which factor is typically considered fixed?

a. Labour b. Capital c. Organization d. Technology

5. What is the formula for calculating average production?

a. AP = Q / K b. AP = Q / L c. AP = Δ Q / Δ L d. AP = Δ Q / Δ K

6. Which type of returns to scale refers to an increase in output at a faster rate than the
increase in inputs?
a. Increasing returns to scale b. Constant returns to scale
c. Diminishing returns to scale d. Negative returns to scale
7. The law of variable proportions is also known as:
a. Law of Supply b. Law of Diminishing Marginal Utility
c. Law of Demand d. Law of Diminishing Returns

8. Isoquants represent:
a. Combinations of factors that produce the same level of output
b. Combinations of factors that produce different levels of output
c. Marginal product of labour
d. Average product of capital

9. What type of economies of scale arise from factors outside the organization?
a. Internal Economies b. External Economies
c. Internal Diseconomies d. External Diseconomies

10. What is the main cause of application of the law of variable proportions?
a. Fixity of any one factor b. Variable technology
b. Unlimited resources d. Homogeneous production function
 BUSINESS ECONOMICS
11. Which of the following is NOT a property of isoquants?
a. Convex to the origin
b. Downward sloping from left to right
c. They intersect with each other
d. Higher isoquant represents a higher level of output

12. Which type of returns to scale refers to a situation where output increases proportionally with
input increase?
a. Increasing returns to scale b. Constant returns to scale
c. Diminishing returns to scale d. Negative returns to scale

13. What is an Isocost line?

a. Locus of factor combinations for a given output
b. Locus of factor combinations for a given total cost
c. Locus of output combinations for a given total cost
d. Locus of output combinations for a given factor input

14. Which type of returns to a factor is a short-term concept?

a. Increasing returns to a factor b. Constant returns to a factor
c. Diminishing returns to a factor d. Negative returns to a factor

15. What is the assumption regarding the state of technology in the law of variable proportions?
a. Constant b. Improving c. Degrading d. Irrelevant

16. What is the law of variable proportions also known as?

a. Law of Supply b. Law of Diminishing Marginal Utility
c. Law of Demand d. Law of Diminishing Returns

17. Which of the following is an example of an implicit cost?

a. Rent b. Raw materials c. Interest on owner's capital d. Wages

18. Isoquants are used to represent:

a. Various levels of output b. Various levels of input
c. Various levels of cost d. Various levels of profit

19. Which of the following types of returns to scale is associated with a decrease in output as
inputs increase?
a. Increasing returns to scale b. Constant returns to scale
c. Diminishing returns to scale d. Negative returns to scale

20. What is the law of variable proportions concerned with?

a. Output and input relationship b. Demand and supply relationship
c. Price and quantity relationship d. None of the above

21. Isoquants are:

a. Upward sloping curves b. Downward sloping curves
c. Vertical lines d. Horizontal lines

22. Which of the following is a short-run concept?

a. Law of Diminishing Returns b. Law of Increasing Returns
c. Law of Constant Returns d. Law of Variable Proportions

23. The iso-cost line represents:

a. Various levels of cost b. Various levels of output
c. Various levels of input d. Various levels of profit
 BUSINESS ECONOMICS

24. The law of variable proportions is based on the assumption of:

a. Constant technology b. Improving technology
c. Decreasing technology d. Variable technology

25. Which type of returns to scale occurs when output increases proportionally with input
increase?
a. Increasing returns to scale b. Constant returns to scale
c. Diminishing returns to scale d. Negative returns to scale

26. Internal economies of scale arise due to:

a. Factors outside the organization
b. Expansion of the organization itself
c. Decrease in the quality of factors outside the organization
d. Scarcity of resources

27. Isoquants do NOT:

a. Intersect with each other b. Have a negative slope
c. Represent various combinations of input d. Represent various levels of output

28. _______ refers to the transformation of inputs into output.

a. Production b. Revenue function
c. Production function d. All of the above
29. Total Product, Marginal Product & Average Product for 1st unit of labor are
a. Identical b. Different c. Unable to be determined d. None of these
30. Law of Variable proportions passes from
a. 2 stages b. 4 stages c. 1 stage d. 3 stages

10 Marks Questions
1. What is production? Explain average product, marginal product and total product.
2. Explain the law of Variable Proportions.
3. Explain the Law of Diminishing Returns
4. Explain the laws of Returns to scale.
5. Explain stages and applicability of law of variable proportions.
6. Explain Isoc-cost line
7. Explain Iso-quant curve.
8. Explain the properties of iso-quant curve
9. Explain the various economies of scale.
10. Explain the diseconomies of scale.
11. Explain in detail factors of economies of scale
12. Explain in detail factors of diseconomies of scale

15 Marks Questions
1. What is production? Explain total product, average product and marginal Product.
2. Explain the law of variable proportions with a diagram.
3. Explain the laws of returns with diagrams.
4. Explain law of variable proportions and its applicability
5. Explain Iso-quant curve and its properties.
6. Explain the various economies and diseconomies of scale .
7. Explain in detail factors of economies and diseconomies of scale
8. Explain in detail Law of Diminishing Returns