CHAPTER-3

Production Analysis: Introduction, Meaning of

Production and Production Function, Cost of
Production.
Cost Analysis: Private costs and Social Costs,
Accounting Costs and Economic costs, Short run and
Long Run costs,
Economies of scale, Cost-Output Relationship - Cost
Function, Cost-Output Relationships in the Short
Run, and Cost-Output Relationships in the Long Run.

8-1
 Production function describes the
relationship between inputs and output

Inputs
Output

8-2
 THE THEORY OF
PRODUCTION
Production: Any activity leading to
value addition – Transformation of
inputs into output
Q= f (L,K)

Production involves transformation of inputs

such as capital, equipment, labor, and
land into output - goods and services

8-3
• In this production process, the manager
is concerned with efficiency in the use of
the inputs
- technical vs. economical efficiency
• Economic efficiency:
• occurs when the cost of producing a given
output is as low as possible
• Technological efficiency:
• occurs when it is not possible to increase
output without increasing inputs 8-4
You will see that basic production theory is
simply an application of constrained
optimization:

the firm attempts either to minimize the

cost of producing a given level of output
or
to maximize the output attainable with a
given level of cost.

Both optimization problems lead to same

rule for the allocation of inputs and choice
of technology
8-5
 Production Function
A production function is purely technical
relation which connects factor inputs &
outputs. It describes the transformation of
factor inputs into outputs at any particular
time period.
Q = f( L,K,R,Ld,T,t)
where
Q = output R= Raw Material
L= Labour Ld = Land
K= Capital T = Technology
t = time

For our current analysis, let’s reduce the inputs to two, capital (K)
and labor (L):Q = f(L, K)
8-6
Production function: tells us the
maximum possible output that can be
attained by the firm for any given
quantity of inputs.

Q = f(L,K,M)
Q = f(P,F,L,A)
Computer Chips = f1(L,K,M)
Econ Mark = f2(Intellect, Study,
Bribe)
8-7
7
Key assumptions
given ‘state of the art’ production technology
whatever input or input combinations are included
in a particular function, the output resulting from their
utilization is at the maximum level

For simplicity we will often consider a production function of

two inputs:
Q=f(X, Y)
Q = output
X = labor
Y = capital 8-8
8
 Basic Concepts of Production Theory

• Inputs are considered variable or fixed depending

on how readily their usage can be changed
• Variable input
• An input for which the level of usage may be changed quite
readily
• Fixed input
• An input for which the level of usage cannot readily be
changed and which must be paid even if no output is
produced
• Quasi-fixed input
• A “lumpy” or indivisible input for which a fixed amount must
be used for any positive level of output
• None is purchased when output is zero
8-9
 Short-Run and Long-Run
Production
• In the short run some inputs are fixed
and some variable
• e.g. the firm may be able to vary the
amount of labor, but cannot change the
amount of capital
• in the short run we can talk about factor
productivity / law of variable
proportion/law of diminishing returns

8-10
• In the long run all inputs become
variable
• e.g. the long run is the period in which
a firm can adjust all inputs to changed
conditions
• in the long run we can talk about
returns to scale

8-11
• 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

8-12
Fill in the table.
VSR SR LR

Any change in All factors are

Some factors are
variable and all
factor No varied but some
required changes are
employment? are fixed
made
Any change in
output level? No Yes Yes
No adjustment —Temporary adjust.
Reasons Time is needed —Time is needed Final adjustment –
to recognize the to identify if the Time is long enough
change, make change is permanent for the final adjust.
decision & & to make gradual to be determined &
implement adjustment to implemented.
adjustment minimize cost
8-13
 Production Function

8-14
8-
Three variables are defined to measure the output:
____________________:
Total product (TP) is the whole amount of output
produced by all the factors employed.
Average product (AP) is the output per unit of the
____________________:
variable factor employed.
____________________:
Marginal product (MP) the change in output resulting
from employing an additional unit of the variable factor.

TP = Q TP Q TP Q
AP   MP  
L L
L L 1 L L 1

8-15
Total, Average, & Marginal Products
of Labor, K = 2
Number of Total product (Q) Average product Marginal product
workers (L) (AP=Q/L) (MP=Q/L)
0 0 -- --
1 52 52 52
2 112 56 60
3 170 56.7 58
4 220 55 50
5 258 51.6 38
6 286 47.7 28
7 304 43.4 18
8 314 39.3 10
9 318 35.3 4
10 314 31.4 -4
8-16
Derivation of the law:

With a given amount of fixed factors, when one worker

is employed, he can use only some of the fixed factors
each time.
When more workers are employed, they can specialize
and raise the productivity. (Both MP & AP ).
However, after all the fixed factors have been
efficiently used, additional workers can help the preceding
workers only. Hence MP  which will finally drag down
AP (and even TP).

8-17
Graphical
illustration: Variable factors Fixed factor

MP
MP Once
Once the
the MP
MP curve
curve
>>
>>

AP passes
passes through
through the
the AP
AP
curve
curve and
and lies
lies below
belowit,it,
AP  the
the AP
AP curve
curve will
will also
also
>>

be
be dragged
dragged down.
down.
Why?
Why?
8-18
bhati
 When
When AP
APrises,
rises, MP
MPmust
must lie
lie above
above
AP.
AP.
When
When AP
APfalls,
falls, MP
MP must
must lie
lie below
below
AP.
AP.
How
Howcan can MPMP lying
lying
above
above APAP become
become lying
lying
below
below it?
it? (If
(If MP
MP curve
curve isis
continuous,
continuous, itit must
must pass
pass
through
through thethe maximum
maximum
point
point of
of AP
AP curve
curve..))

8-19
bhati
Features:

The
The slope
slope of
of TP
TP
curve
curve isis MP.
MP.

The
The slope
slope of
of the
the
line
line joining
joining the
the
origin
origin and
and aa
point
point onon TP
TP isis
AP.
AP.

Notice
Notice the
the
points
points where
where
MP
MP == maxi.;
maxi.;
MP=AP
MP=AP & &
MP
MP == 0.
0. 8-20
Q Production as workers increase
Each Each
Each Additional Additional
Additional worker worker
worker Is less Decreases
Is equally productive Production
productive

Each
Additional
worker
Is more
Total Product
productive

L 8-21
21
 Implications of the law (if the law is violated)

By adding units of fertilizer or worker continuously to a

given plot of land, no matter how small its size is, TP can be
increased continuously. Enough food can be produced to
feed all the people in the world.

An infinitesimal piece of land is adequate to supply the

amount of food required. Hence the supply of land is no
longer scarce.  Land price would drop to zero.

MP of workers cultivating superior land does not fall and is

always larger than MP of workers cultivating inferior land.
 No inferior land would be cultivated.
8-22
Implications of the law (if the law holds)

If the amount of land is fixed, TP cannot be

increased significantly (∵ MP & AP ) to feed all
the people in the world.
Hence to raise production, more land is needed.
However, as the supply of land is limited and scarce,
under competition, land price must be positive.
Once MP of superior land falls below MP of
inferior land, inferior land will also be cultivated.

8-23
 Law of Diminishing Marginal
Product (Returns)
• Only holds in the short-run
• As the quantity of the variable input (labor)
increases, the capital to labor ratio
declines
• Eventually an incremental increase in the
variable input adds less to output than the
previous incremental increase in the
variable input
8-24
8-
Production in the Short Run

Consider a production process where K, R and technology are

fixed: As L is changed, the output
Production of Good X
changes, QX= f(L)
L = labour input L TPL APL MPL
TPL = QX = output of good X
0 0 0 --
APL = average product [TP/L] L = 1 TPL=4
MPL = Marginal product [TP/ L]
1 4 4 4
TPLL 2 10 5 6
APLL==
AP
L 3 20 6.67 10
TPL 4 25 6.25 5
MPL =
L 5 29 5.8 4
TPL output 32 5.3 3
APL = = = Efficiency 6
L input 7 34 4.87 2
Maximum of APL is at the 3 input of 1
8 35 4.37
labour.
9 35 3.89 0
8-25
 Production in the Short Run

TPL output
APL = = = Efficiency of Production of Good X
L input labour L TPL APL MPL
Notice that the APL increases as the first 0 0 0 --
three units of labour are added to the 1 4 4 4
fixed inputs of K and R. The maximum
2 10 5 6
efficiency of Labour or maximum APL , given
3 20 6.67 10
our technology, plant and natural
resources is with the third worker. 4 25 6.25 5
As additional units of labour are added 5 29 5.8 4
beyond the third worker the 6 32 5.3 3
output per worker [APL ] declines. 7 34 4.87 2
8 35 4.37 1
9 35 3.89 0
8-26
 Graphically TPL can be shown:
TPL initially increases at an increasing L TPL
rate; it is convex from below.
Output, QX
. . . . TPL 0 0

.
35 1 4

.
Maximum
30 output 2 10
25
20 . After some point it
3
4
20
25

.
then increases at a 5 29
15
decreasing rate and 32
6

. reaches a maximum
10

.
7 34
5 level of output,
and declines
8 35
1 2 3 4 5 6 7 8 9 9 35
Labour
8-27
 Given the TP , the APL can calculated: TPL L APL
APL = TPL = output = Efficiency of 0 0 0
L input labour 4 1 4
10 2 5
20 3 6.67
APL
25 4 6.25
10

. .
29 5 5.8

.
8
6

4 . . .. ..
32
34
6
7
5.3
4.87
4.37
35 8
2
. 1 2 3 4 5 6 7 8 9
APL 35 9 3.89

Labour
8-28
 Output, QX
35 Z
Z W

.
.
TPL

.
.
The APL is the

.
.
30 slope of a Graphically the relationship
between APL and TPL can be shown:

.
ray from
25
the origin M 1 unit of L produces 4Q,
20 to the 5 APL is 4/1 = 4 or the
=
n slope of line 0H.
TPL . r/ u H
.
15 e
ris 4
2 units of L produces 10Q,
=
10 /r u n APL is 10/2 = 5 or the slope of line 0M.

. ri se
3 units of L produces 20Q,
5
4
0
APL10
. 1 2 3 4 5 6 7
APL is 20/3 = 6.67 or the slope of line 0Z.
8 9 4 units of L produces 25Q,

.
Labour

.
APL is 25/4 = 6.25 or

. .. .
8

..
the slope of line 0W.

.
6
As additional units of L are added,
4
the AP falls.
2 The maximum AP is where

. 1 2 3 4 5 6 7 8 9 APL the ray with the greatest

Labour slope is tangent to the TP.
8-29
 Output, QX
35

.
.
TPL

.
Given TPL , the APL was

.
.
30
calculated and graphed.

.
25 MPL was calculated as L APLL TPL
MP
20 the change in TPL given a
change in L. 0 --
0 0
4-0
15
10 . The first unit of labour added
4 units of output.
1
2
44
65
4
10

. .
5
4
0
. “Between” the 1st and 2cd units
of labour, Q increases by 6. 10
3 6.67
4 6.25
5
20
25
APL10 1 2 3 4 5 6 7 8 9

.
Labour 5 5.8
4 29
8

. . .. . . .
Note: Where MPL = APL, APL 3
6 5.3 32

.. ... ..
MPL = APL
6 is a maximum. 7 4.87
2 34
4 1 35
8 4.37

.
2
. . APL
MP
0
9 3.89 35
Remember: MP is graphed
at “between” units of L. 8-30
1 2 3 4 5 6 7 8 9
L
Labour
 Output, QX Z
35

.
.
TPL

.
.
.
30 Useful things to notice:
1. MPL is the slope of TPL.

.
25
2. When TPL increases at an increasing
20 rate, MPL increases. At the inflection

.
point in the TPL , MPL is a maximum.
15
When TPL increases at a decreasing rate,
10 MPL is decreasing.
5
4
0. .. 3. The APL is a maximum when:
a. MPL = APL ,
b. the slope of the
APL10 1 2 3 4 5 6 7 8 9 ray from origin is tangent to

.
Labour TPL .
8

. . .. . . .
... ..
4. When MPL > APL the APL is increasing.

..
6 When MPL < APL the APL is decreasing.
4 5. When MPL is 0, the
2
. . . APL
MP
slope of TPL is 0, and TP
is a maximum.

1 2 3 4 5 6 7 8 9 L
8-31
Labour
Summary: TPL , MPL and APL
In many production processes Z
Q initially increases at an TPL
TPL At the
increasing rate. This is due to inflection
division of labour and a “better” point
mix of the variable input with the Diminishing
fixed inputs. marginal
product
As Q [TPL ]increases at an increasing
rate, MP increases.
As Q [TPL ]increases at a 0 L
MPL MPL is {MP< AP,
decreasing rate, MPL decreases.
Where 0Z is tangent to TP , AP is a APL a max AP falls}
L L
maximum; APL = MPL .
When TPL is a maximum, MPL is zero. APL
When TPL is decreasing, MPL is MPL
negative. {MP> AP, AP rises} L1 L 2 L3 L
8-32
 To calculate AP:
PRODUCTION TPL
APL =
LABOUR KAPITAL OUTPUT MP AP
L
0 5 0
TPL = 8 0 0 = ? AP is a maximum
L= 1
1 5 8 8 TP8.0
L = 15
8 1 = 8 when L = 4.
L= 1
2 5 23 15 TP11.5
L = 19
23 2 = 11.5 Note that MP is
L= 1
3 5 42 19 14.0
TPL = 15 42 3 = 14 15 between 3rd & 4th
4 L=
5 1 57 15 TP14.25 574 = 14.25 units of L, it is 10
L = 10
5 L=
5 1 67 10 TP13.4 67 5 = 13.4
between 4th & 5th,
L= 7 so it equals
6 L=
5 1 74 7 12.33 AP = 14.25 at L=4.
7 5 79 5 11.28
8 5 82 3 10.25
1
To calculate MP:
9 5 83
9.22 TPL
10 5 82 -1 8.2 MPL = L
MP is a maximum between 2cd and 3rd unit of L.
8-33
 As L is added to production
PRODUCTION process, output per worker [AP]
increases. to a maximum
LABOUR KAPITAL OUTPUT MP AP “efficiency” [output/input which
occurs at L = 4.
0 5 0 0
1 5 8 8 8.0 MP increases to a max between
2 5 23 15 11.5 the 2cd & 3rd units of L.
3 5 42 19 14.0 When MP > AP the output per
4 5 57 15 14.25 worker is increasing.
5 5 67 10 13.4
Division of Labour and a more
6 5 74 7 12.33 efficient mix of L, K & R causes
7 5 79 5 11.28 AP to increase.
8 5 82 3 10.25 Output per worker decreases
9 5 83 1 9.22 after the 4th worker. “Too
10 5 82 -1 8.2 many” workers for K, R & tech,
Diminishing Marginal Productivity begins MP< AP.
with the 4rth unit of L.
8-34
 Law of Variable Proportions
Increasing Returns- Stage I:
TPl increases at an increasing rate.
Fixed factor (K) is abundant and variable
factor is inadequate. Hence K gets utilised
better with every additional unit of labour

8-35
Stage II- TPl continues to increase but at a
diminishing rate.
stage III- TPl begins to decline –Capital becomes
scarce as compared to variable factor. Hence
over utilisation of capital and setting in of
diminishing returns
Causes of 3 stages: Indivisibility and inelasticity
of fixed factor and imperfect substitutability
between K and L

8-36
 Law of Variable Proportions
Significance of Law of Diminishing Marginal
Returns:
- Empirical law, frequently observed in
various production activities
- Particularly in agriculture where natural
factors (say land), which play an important
role, are limited.
- Helps manager in identifying rational and
irrational stages of operation
8-37
 Law of Variable Proportions
- It provides answers to questions such as:
a) How much to produce?
b) What number of workers (and other
variable factors) to employ in order to
maximize output
In our example, firm should employ a
minimum of 7 workers and maximum of 10
workers (where TP is still rising)
8-38
 Law of Variable Proportions
- Stage III has very high L-K ratio- as a
result, additional workers not only prove
unproductive but also cause a decline in
TPl.
- In Stage I capital is presumably under-
utilised.
- So a firm operating in Stage I has to
increase L and that in Stage III has to
decrease labour.
8-39
 LAW OF RETURN TO SCALE
• ECONOMIES OF SCALE
• TRUE ONLY UP TO A POINT.
• THEN DIS-ECONOMIES SETS IN.
• THREE STAGES
• INCREASING RETURNS – MARGINAL RETURN RISES
• CONSTANT RETURNS – MARGINAL RETURN CONSTANT
• DIMINISHING RETURNS – MARGINAL RETURN
DIMNISHES

8-40
 RETURNS TO SCALE
(PRODUCTION OF AMN SHELLS IN ORD FACTORY PER MACHINE)
TOTAL MARGINAL STAGE OF
FACTORS OF PRODN EMP PRODUCTS/ PRODUCT/ RETURN TO
RETURNS RETURNS SCALE

8-41
 RETURNS TO SCALE
(PRODUCTION OF AMN SHELLS IN ORD FACTORY PER MACHINE)
TOTAL MARGINAL STAGE OF
FACTORS OF PRODN EMP PRODUCTS/ PRODUCT/ RETURN TO
RETURNS RETURNS SCALE
1 WORKER+3 hrs

8-42
 RETURNS TO SCALE
(PRODUCTION OF AMN SHELLS IN ORD FACTORY PER MACHINE)
TOTAL MARGINAL STAGE OF
FACTORS OF PRODN EMP PRODUCTS/ PRODUCT/ RETURN TO
RETURNS RETURNS SCALE
1 WORKER+3 hrs
2 WORKERS + 6 hrs

8-43
 RETURNS TO SCALE
(PRODUCTION OF AMN SHELLS IN ORD FACTORY PER MACHINE)
TOTAL MARGINAL STAGE OF
FACTORS OF PRODN PRODUCTS/ PRODUCT/ RETURN TO
EMP RETURNS RETURNS SCALE
1 WORKER+3 hrs
2 WORKERS + 6 hrs

3 WORKERS + 9hrs
4 WORKERS+ 12 hrs
5 WORKERS +15 hrs
6 WORKERS + 18 hrs.

7 WORKERS + 21 hrs
8 WORKERS + 24 hrs
9 WORKERS + 27 hrs
8-44
 RETURNS TO SCALE
(PRODUCTION OF AMN SHELLS IN ORD FACTORY PER MACHINE)
TOTAL MARGINAL STAGE OF
FACTORS OF PRODUCTS/RE PRODUCT/ RETURN TO
PRODN EMP TURNS RETURNS SCALE
1 WORKER+3 hrs 200
2 WORKERS + 6 hrs 500

3 WORKERS + 9hrs 900

4 WORKERS+ 12 hrs 1400
5 WORKERS +15 hrs 1900
6 WORKERS + 18 hrs. 2400

7 WORKERS + 21 hrs 2800

8 WORKERS + 24 hrs 3100
9 WORKERS + 27 hrs 3200
8-45
 RETURNS TO SCALE
(PRODUCTION OF AMN SHELLS IN ORD FACTORY PER MACHINE)
TOTAL MARGINAL STAGE OF
FACTORS OF PRODN PRODUCTS/ PRODUCT/ RETURN TO
EMP RETURNS RETURNS SCALE
1 WORKER+3 hrs 200 200
2 WORKERS + 6 hrs 500 300

3 WORKERS + 9hrs 900 400

4 WORKERS+ 12 hrs 1400 500
5 WORKERS +15 hrs 1900 500
6 WORKERS + 18 hrs. 2400 500

7 WORKERS + 21 hrs 2800 400

8 WORKERS + 24 hrs 3100 300
9 WORKERS + 27 hrs 3200 100
8-46
 RETURNS TO SCALE
(PRODUCTION OF AMN SHELLS IN ORD FACTORY PER MACHINE)
TOTAL MARGINAL STAGE OF
FACTORS OF PRODN PRODUCTS/ PRODUCT/ RETURN TO
EMP RETURNS RETURNS SCALE
1 WORKER+3 hrs 200 200 STAGE OF
2 WORKERS + 6 hrs 500 300 INCREASING
RETURNS
3 WORKERS + 9hrs 900 400
4 WORKERS+ 12 hrs 1400 500
5 WORKERS +15 hrs 1900 500 STAGE OF
6 WORKERS + 18 hrs. 2400 500 CONSTANT
RETURNS
7 WORKERS + 21 hrs 2800 400 STAGE OF
8 WORKERS + 24 hrs 3100 300 DECREASING
RETURNS
9 WORKERS + 27 hrs 3200 100
8-47
 LAW OF RETURN TO SCALE

OPTIMAL POINT IN
EMPLOYMENT OF FACTORS

STAGE 2
4 STAGE 1
MARGINAL
STAGE 3
3
OUTPUT MARGINAL
2 PRODUCT
CURVE
1
0
1 2 3 4 5 6 7 8 9 10 11
8-48
NO OF COMPOSITE UNITS OF FACTORS OF PRODUCTION
 LAW OF RETURN TO SCALE

• DIS-ECONOMIES START OPERATING AS

SCALE OF ACTIVITY IS RAISED BEYOND
A POINT.
• OPTIMUM MIX OF INPUTS TO ACHIEVE
THE RESULT VARIES WITH THE
DEGREE OF RESULT DESIRED.
• APPLICABLE IN LONG RUN.
8-49
 Returns to Scale
f(cL, cK) = zQ

• If all inputs are increased by a factor of c &

output goes up by a factor of z then, in
general, a producer experiences:
• Increasing returns to scale if z > c; output goes up
proportionately more than the increase in input usage
• Decreasing returns to scale if z < c; output goes up
proportionately less than the increase in input usage
• Constant returns to scale if z = c; output goes up by the
same proportion as the increase in input usage

8-50
9-
 How much will output increase when ALL inputs increase by a
particular amount?
RTS = [%Q]/[%(all inputs)]

1% increase in inputs => more than 1% increase in output, increasing

returns to scale.

1% increase in inputs => 1% increase in output

constant returns to scale.

1% increase in inputs => a less than 1% increase in output, decreasing

returns to scale.

8-51
51
 Why are returns to scale important?
If an industry faces DECREASING returns to
scale, small factories make sense
-It is easier to have small firms in this industry

If an industry faces INCREASING returns to

scale, large factories make sense
-Large firms have an advantage; natural
monopolies
8-52
52
NOTES:
• The marginal product of a single factor
may diminish while the returns to scale do
not

• Marginal product deals with a SINGLE

input increasing, while returns to scale
deals with MULTIPLE inputs increasing

• Returns to scale need not be the same at

different levels of production
8-53
 Economies of Scale
• Internal – advantages that arise as a result
of the growth of the firm
• Technical
• Commercial
• Financial
• Managerial
• Risk Bearing

8-54
 Economies of Scale
• External economies of scale – the advantages
firms can gain as a result
of the growth of the industry – normally
associated with a particular area
• Supply of skilled labour
• Reputation
• Local knowledge and skills
• Infrastructure
• Training facilities

8-55
 Economies of Scale
Capital Land Labour Output TC AC

Scale A 5 3 4 100

Scale B 10 6 8 300

•Assume each unit of capital = Rs. 5, Land = Rs.

8 and Labour = Rs. 2
•Calculate TC and then AC for the two different
‘scales’ (‘sizes’) of production facility
•What happens and why?

8-56
 Economies of Scale
Capital Land Labour Output TC AC

Scale A 5 3 4 100 57 0.57

Scale B 10 6 8 300 164 0.54

•Doubling the scale of production (a rise of 100%) has led

to an increase in output of 200% - therefore cost of
production
•PER UNIT has fallen
•Don’t get confused between Total Cost and Average Cost
•Overall ‘costs’ will rise but unit costs can fall
•Why?
8-57
 Economies of Scale
• Internal: Technical
• Specialisation – large organisations
can employ specialised labour
• Indivisibility of plant – machines can’t be broken down
to do smaller jobs!
• Principle of multiples – firms using more than one
machine of different capacities - more efficient
• Increased dimensions – bigger containers can reduce
average cost

8-58
 Economies of Scale
• Indivisibility of Plant:
• Not viable to produce products
like oil, chemicals on small scale – need
large amounts of capital
• Agriculture – machinery appropriate for
large scale work – combines, etc.

8-59
 Economies of Scale
• Principle of Multiples:
• Some production processes
need more than one machine
• Different capacities
• May need more than one machine to be
fully efficient

8-60
 Economies of Scale
• Principle of Multiples: e.g.
Machine A Machine B Machine C Machine D
Capacity = Capacity = Capacity = Capacity =
10 per hour 20 per hour 15 per hour 30 per hour
Cost = Rs. Cost = Rs. Cost = Rs. Cost = Rs.
100 per 50 per 150 per 200
machine machine machine per machine
Company A = 1 of each machine, output per hour = 10
Total Cost = Rs. 500
AC = Rs. 50 per unit
Company B = 6 x A, 3 x B, 4 x C, 2 x D – output per hour = 60
Total Cost = Rs. 1750
AC = Rs. 29.16 per unit
8-61
 Economies of Scale
Increased Dimensions: e.g.
Transport container = Volume of 20m3
Total Cost: Construction, driver, fuel,
2m maintenance, insurance, road tax =
2m Rs. 600 per journey
5m AC = Rs. 30m3

Total Cost = Rs. 1800

per journey
AC = Rs. 11.25m3

4m

4m

10m
Transport Container 2 = Volume 160m3
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 Economies of Scale
• Commercial
• Large firms can negotiate favourable
prices as a result
of buying in bulk
• Large firms may have advantages in
keeping prices higher because
of their market power

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 Economies of Scale
• Financial
• Large firms able to negotiate cheaper
finance deals
• Large firms able to be more flexible about
finance – share options, rights issues, etc.
• Large firms able to utilise skills of
merchant banks to arrange finance

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 Economies of Scale
• Managerial
• Use of specialists – accountants,
marketing, lawyers, production,
human resources, etc.

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 Economies of Scale
• Risk Bearing
• Diversification
• Markets across regions/countries
• Product ranges
• R&D

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 Economies of Scale

Minimum Efficient Scale – the point

at which the increase in the scale of production
yields no significant unit cost benefits

Minimum Efficient Plant Size – the

point where increasing the scale of production of an
individual plant within the industry yields
no significant unit cost benefits

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 Economies of Scale
Unit Cost

Scale A
82p

Scale B
54p

LRAC

MES Output
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 Diseconomies of Scale
• The disadvantages of large scale production
that can lead to increasing average costs
• Problems of management
• Maintaining effective communication
• Co-ordinating activities – often across
the globe!
• De-motivation and alienation of staff
• Divorce of ownership and control

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