UNIT 3

FORMS OF BUSINESS ORGANIZATIONS AND THEORY OF PRODUCTION

NATURE OF THE FIRM

FACTORS OF PRODUCTION CAN BE PRODUCE ANY THING BY THEMSELVES UNLESS SOMETHING IS THEIR TO COORDINATE THEIR EFFORT. THIS IS TERMED AS ENTREPRENEURSHIP, BUSINESS ENTERPRISE OR FIRM.

NATURE OF THE FIRM

FIRM OR BUSINESS ENTERPRISE EXIST FOR MANY REASONS, BUT THE MOST IMPORTANT ARE: EXPLOIT ECONOMIES OF SCALE. EFFICIENT PRODUCTION REQUIRED SPECIALIZED MACHINERY, ASSEMBLY LINE. TO RAISE FUNDS TO ORGANIZE / MANAGE THE PRODUCTION PROCESS.

TYPES OF BUSINESS FIRMS

1. SOLE PROPRIETORSHIP (ENTREPRENEURSHIP) 2. PARTNERSHIP 3. LIMITED COMPANIES - PUBLIC LIMITED COMPANY - PRIVATE LIMITED COMPANY - COMPANIES LIMITED BY GUARANTEE

SOLE PROPRIETORSHIP
IT IS ONE MAN CONCERN, IN WHICH HE INVEST HIS OWN MONEY AND MAY ARRANGE THE LOAN BY HIMSELF. HE HAS THE SOLE RESPONSIBILITY OF THE BUSINESS. HE INITIATES, ORGANIZE, DIRECTS ALL ECONOMIC ACTIVITIES AND TAKES THE ENTIRE RISK.

ADVANTAGES OF SOLE PROPERTIORSHIP

1. THE COMBINATION OF FINANCIAL INTERESTS AND SOLE RESPONSIBILITY FOR RUNNING THE BUSINESS IS CONDUCIVE TO EFFICIENCY. 2. ALL ACTIVITIES LIKE TRANSACTIONS AND OPERATIONS ARE PERFORMED IN THE MOST ECONOMICAL MANNER AND ALL KINDS WASTE IS ELIMINATED.

ADVANTAGES OF SOLE PROPERTIORSHIP

3. EASIEST TO START AND EASIEST TO WINDUP. 4. POSSIBILITY TO ATTEND ALL CUSTOMERS WITH FULL ATTENTION AND GIVE SATISFACTION TO THEM AT MINIMUM COST.

LIMITATIONS FOR SOLE PROPERTIORSHIP

1. CAPITAL AT THE COMMAND OF SOLE PROPRIETOR IS GENERALLY MEAGER. 2. MANY SIDES OF BUSINESS MAY HINDER THE EFFICIENCY OF ONE MAN. 3. LARGE SCALE PRODUCTION CAN NOT BE ECONOMICAL.

PARTNERSHIP
IN THIS FORM MORE THAN ONE PERSON CAN COMBINE, CONTRIBUTE CAPITAL, AND AGREE TO SHARE PROFIT & LOSS LOSSES IN DEFINED PROPORTIONS. UNDER THIS SYSTEM PARTNERS CAN GET INTEREST ON THEIR CAPITAL AND ACTIVE WORKING PARTNER CAN CLAIM THE SALARY FOR HIS WORK. ALL OF THESE WILL DEPEND ON TERMS OF THEIR PARTNERSHIP AGREEMENT.

ADVANTAGES OF PARTNERSHIP
1. MASS RESOURCES CAN BE COMMANDED 2. POSSIBILITY TO ESTABLISH WIDER PERSONAL CONTACTS. 3. BUSINESS ON LARGER SCALE CAN BE ENJOYED WITH ECONOMY. 4. OWNERSHIP & MANAGEMENT UNION IS A SPUR TO EFFICIENCY AND ECONOMICAL TASKS.

ADVANTAGES OF PARTNERSHIP
5. PROMPT RESPONSE TO CHANGES IN BUSINESS CONDITIONS AND HIGHLY ADAPTABLE. 6. EXISTENCE OF UNLIMITED LIABILITIES CURB THE SPECULATIVE TENDENCIES OF PARTNERS, AND PREVENTS THE RASHLY AND RISKY ENTERPRISES.

LIMITATIONS FOR PARTNERSHIP

1. SELFISH BEHAVIOR TO GET MAXIMUM OUT OF THE BUSINESS & DOING MINIMUM IS SEEN IN ACTUAL PRACTICE. 2. ACCORDING TO THE LAW IN CASE OF PARTNERS RETIREMENT, DEATH, BANKRUPTCY, OR SOLVENCY, PARTNERSHIP MUST BE DISSOLVE, SO NO CONTINUITY OF BUSINESS EXISTENCE CAN BE ASSURED.

LIMITATIONS FOR PARTNERSHIP

3. UNLIMITED LIABILITIES MAKE THE POLICIES OF FIRM TIMID AND UNENTERPRISING. 4. LIMITED PARTNERSHIP RESOURCES MAY HINDER THE LAUNCHING OF LARGE SCALE BUSINESS.

PRIVATE LIMITED COMPANY

THIS IS A KIND OF COMPANY WHICH BY ITS ARTICLES RESTRICTS THE RIGHT TO TRANSFER ITS SHARES, LIMITS THE NUMBER OF ITS MEMBERS TO FIFTY (EXCLUDING THE EMPLOYEES) AND PROHIBITS ANY INVITATION TO THE PUBLIC TO SUBSCRIBE FOR ANY OF ITS SHARES OR DEBENTURES.

PUBLIC LIMITED COMPANY

A COMPANY WHICH IS NOT A PRIVATE COMPANY, THAT IS, WHICH DOES NOT OBSERVE ANY OF THE THREE RESTRICTIONS OF THE PRIVATE LIMITED COMPANY, IS KNOWN AS A PUBLIC LIMITED COMPANY.

ADVANTAGES OF CORPORATE FORM OF ORGANIZATION

1. Limited liability
THE STOCKHOLDERS OR OWNERS OF THE CORPORATION ARE LIABLE ONLY TO THE EXTENT OF THEIR HOLDING OF SHARES IN THE CORPORATION AND IT IS LIMITED TO THE AMOUNT OF THEIR INVESTMENT. 2. EASE OF ACCUMULATION OF CAPITAL THE OWNERSHIP OF CORPORATION CAN EASILY BE TRANSFERRED WHICH PERMITS THE LARGE OR SMALL INVESTORS TO PARTICIPATE IN OWNER SHIP.

ADVANTAGES OF CORPORATE FORM OF ORGANIZATION

3.
TRANSFERABILITY OF SHARES THE STOCKS OF A CORPORATION CAN BE SOLD BY ONE INVESTOR TO ANOTHER WITHOUT DISTURBING THE BUSINESS OF THE ORGANIZATION. IT CAN ALSO BE SOLD THROUGH STOCK EXCHANGES WHERE THESE STOCKS ARE LISTED.

ADVANTAGES OF CORPORATE FORM OF ORGANIZATION

4.

5.

CONTINUOUS EXISTENCE SINCE THE OWNERS AND MANAGEMENT IN CASE OF CORPORATIONS ARE DIFFERENT ENTITY, THEREFORE, CORPORATIONS HAVE CONTINUOUS LIFE AND OPERATION. ITS WORKING CANNOT BE DISTURBED WITH THE CHANGE OF OWNERSHIP. PROFESSIONAL MANAGEMENT

DISADVANTAGES OF CORPORATE FORM OF ORGANIZATION

1. HEAVY TAXES THE NET PROFIT OF CORPORATION IS LIABLE TO PAY HEAVY TAXES AS COMPARED TO OTHER FORM OF BUSINESS. 2. GREATER REGULATIONS CORPORATION COMES INTO EXISTENCE UNDER THE COMPANIES ORDINANCE 1984, WHICH PROVIDE LOT OF REGULATIONS WHICH ARE NOT REQUIRED IN OTHER FORMS OF BUSINESS.

DISADVANTAGES OF CORPORATE FORM OF ORGANIZATION

3. SEPARATION OF OWNERSHIP AND CONTROL THE SEPARATION MAY BE OF DISADVANTAGE SUCH AS RUNNING OPERATION FOR THE BENEFIT OF INSIDERS AND NOT FOR STOCK HOLDERS.

PRODUCTION FUNCTION
IT IS THE NAME GIVEN TO PHYSICAL RELATIONSHIP OF INPUT AND OUTPUT GIVEN A PARTICULAR STATE OF TECHNICAL KNOWLEDGE. IT CONCERNS WITH THE FLOW OF INPUT AND FLOW OF OUTPUT OVER A PERIOD OF TIME. IT SHOWS THE MAXIMUM AMOUNT OF THAT CAN BE PRODUCED FROM A GIVEN SET OF INPUTS.

PRODUCTION FUNCTION
EVERY MANUFACTURER WANTS TO KNOW THAT HOW MUCH INPUTS SUCH AS LAND, LABOR AND CAPITAL IS REQUIRED TO PRODUCE A UNIT OF OUTPUT DURING A PERIOD OF TIME. BY THIS WE CAN INDICATE THE VARIETIES OF PRODUCTIVE RESOURCES AND THEIR POSSIBLE COMBINATIONS OF PRODUCTIVE RESOURCES.

FACTORS AFFECTING PRODUCTION FUNCTION

1. 2. 3. 4. 5. 6. QUANTITIES OF RESOURCE USED STATE OF TECHNICAL KNOWLEDGE POSSIBLE PROCESS EMPLOYED SIZE OF THE FIRMS NATURE OF FIRM / ORGANIZATION RELATIVE PRICES OF THE FACTORS OF PRODUCTION AND THE MANNER IN WHICH THE FACTORS OF PRODUCTION ARE COMBINED

TOTAL, AVERAGE AND MARGINAL PRODUCT

TOTAL PRODUCT: THE TOTAL AMOUNT OF OUTPUT PRODUCED IN PHYSICAL UNITS ON THE BASIS OF ANY FACTOR OF PRODUCTION. MARGINAL PRODUCT: IT IS THE EXTRA PRODUCT OR OUTPUT ADDED BY ONE EXTRA UNIT OF INPUT. AVERAGE PRODUCT: AVERAGE EQUALS TOTAL DIVIDED BY NUMBER OF INPUT UNITS

TOTAL, AVERAGE AND MARGINAL PRODUCT

UNITS OF LAB. TOTAL PROD. 0 1 2 0 2,000 2,000 1,000 3,000 500 1,500 2,000 MARG. PROD. AVERAGE PR.

3
4 5

3,500
300 3,800 100 3,900

1,167
950 780

LAW OF DIMINISHING RETURN

BY USING PRODUCTION FUNCTION WE CAN HAVE THE UNDERSTANDING OF FAMOUS LAW OF DIMINISHING RETURN. THE LAW OF DIMINISHING RETURN STATES THAT WE WILL GET LESS AND LESS EXTRA OUTPUT WHEN WE ADDED ADDITIONAL UNITS OF INPUTS WHILE HOLDING OTHER INPUTS CONSTANTS. IN OTHER WORDS THE MARGINAL PRODUCT OF EACH UNIT OF OUTPUT WILL DECLINE AS THE AMOUNT OF INPUT INCREASES.

LAW OF DIMINISHING RETURN

THIS LAW CAN BE STUDIED FROM TWO POINTS OF VIEWS: 1. AS IT APPLIES TO CULTIVATION OF LAND 2. AS IT APPLIES TO AVERY WHERE, THE LAW IN ITS GENERAL FORM THIS LAW EXPLAINS WHY UNDERDEVELOPED COUNTRIES ARE POOR, BECAUSE OF NOT USING MECHANIZED FARMING AND FERTILIZER, THE MARGINAL OUTPUT OF WORKERS ARE LOW.

LAW OF DIMINISHING RETURN

FOR EXAMPLE IF WE CONSIDER THE EXAMPLE OF ONE INPUT WHICH IS LABOR. WHEN IT IS ADDED TO FIXED AMOUNT OF LAND, MACHINERY AND OTHER INPUTS, THE LABOR HAS LESS AND LESS MARGINAL OUTPUT.
UNITS OF LABOR TOTAL PRODUCTION MARGINAL PRODUCTION

0
0

2000 3000 3500 3800 3900

2000 1000 500

300

100

LAW OF DIMINISHING RETURN

4000 3000

2000
1000 0 1 2 3 4 5

LIMITATIONS OF LAW OF DIMINISHING RETURN

1. IMPROVED METHODS OF CULTIVATION 2. NEW SOIL 3. INSUFFICIENT CAPITAL

LAW OF DIMINISHING RETURN IN GENERAL FORM

THE LAW OF DIMINISHING RETURN SIMPLY REFERS TO THE COMBINATIONS OF DIFFERENT FACTORS. IN A GENERAL WAY IT CAN BE STATED THAT IF A VARIABLE FACTOR IS COMBINED WITH FIXED FACTORS THE MARGINAL RETURN FOR THAT FACTOR WILL DECREASE.

CAUSES OF DIMINISHING RETURN

1. FIXED PRODUCTIVE CAPACITY OF LAND 2. SCARCITY OF FACTORS SUCH AS LAND AND CAPITAL, FERTILIZER, LESS RAIN 3. LIMITED CAPACITY FOR ORGANIZATION AND SUPERVISION 4. DEFECTIVE COMBINATION OF INPUT FACTORS. 5. ONE FACTOR CANNOT BE FULLY SUBSTITUTED BY OTHER.

RETURN TO SCALE
LAW OF DIMINISHING RETURN DEALS WITH ONLY EFFECT OF ONE INPUT, BUT WHEN WE WANT TO FIND OUT THE EFFECT OF ALL INPUTS, SUCH AS WHAT HAPPENED IF WE INCREASE LAND, WATER AND CAPITAL ALONG WITH THE INCREASE OR DECREASE IN LABOR BY SAME PROPORTION. IN RETURN TO SCALE WE TRY TO ANALYZE THE EFFECT OF INCREASING ALL INPUTS.

RETURN TO SCALE
THERE ARE THREE STAGES OF RETURNS TO SCALE: 1. FIRST STAGE: INCREASING RETURN 2. SECOND STAGE: CONSTANT RETURN 3. THIRD STAGE: DECREASING RETURN. FOR EXAMPLE IF WE CONSIDER TWO INPUTS LABOR AND LAND WHILE MAINTAINING OTHER FACTORS CONSTANT.

RETURN TO SCALE
LABOR LAND TOTAL PRODU. MARG. RETURN STAGE

2 3 4 5 6 7 8 9

2 3 4 5 6 7 8 9

6 9 12 15 18 21 24 27

5 9 14 19 24 28 31 33

3 4 5 5 5 4 3 2

1 1 1 2 2 3 3 3

RETURN TO SCALE
M A R G I N A L 6 STAGE 2 5 4 STAGE 1 3 2 1 0 1 2 3 4 5 6 SCALE

STAGE 3

10

ANALYSIS OF COST
EVERY WHERE THAT PRODUCTION GOES, COSTS FOLLOW BEHIND LIKE A SHADOW. ORGANIZATIONS HAVE TO PAY FOR THEIR INPUTS AND IT INFLUENCE THE LEVEL OF PRODUCTION AND THEIR REVENUE. ORGANIZATIONS HAVE TO PAY CLOSE ATTENTION TO THEIR COSTS. BY ANALYSIS OF COST WE CAN DETERMINE THE SUPPLY DECISIONS OF THE ORGANIZATIONS.

TYPES OF COSTS
1. TOTAL COST 1.1 AVERAGE TOTAL COST 1.2 MARGINAL TOTAL COST 2. FIXED COST 2.1 AVERAGE FIXED COST 2.2 MARGINAL FIXED COST 3. VARIABLE COST 3.1 AVERAGE VARIABLE COST 3.2 MARGINAL VARIABLE COST

TOTAL COST
THIS IS THE SUM TOTAL OF ALL THE COSTS INCURRED BY THE PRODUCER TO PRODUCE A CERTAIN QUANTITY OF OUTPUT. IT INCLUDES PAYMENTS MADE FOR THE USE OF THE FACTORS OF PRODUCTION, THE RAW MATERIAL COST AND OVERHEADS.

FIXED COST
IN A SHORT RUN THERE ARE CERTAIN INPUTS THAT CANNOT BE VARIED WITH THE QUANTITY TO BE PRODUCED. IF OTHER WORDS IT IS THAT COST WHICH IS NOT DIRECTLY LINKED WITH THE QUANTITY OF PRODUCTION. NO MATTER WHAT THE OUTPUT FIXED COST REMAINS THE SAME. SUCH AS RENT OF THE BUILDING.

VARIABLE COST
VARIABLE COST IS THAT PORTION OF COST WHICH IS DIRECTLY RELATED TO THE QUANTITY OF PRODUCTION. IT IS THE COST OF THOSE VARIABLES WHICH VARIES WITH THE OUTPUT. EXAMPLES OF RAW MATERIAL, LABOR ETC.

MARGINAL COST
IT IS THE COST OF PRODUCING ONE EXTRA UNIT OF OUT PUT. FOR EXAMPLE IF THE FIRM IS PRODUCING 1000 COMPACT DISCS FOR A TOTAL COST OF Rs.10,000 AND IF THE TOTAL COST OF PRODUCING 1,001 DISCS ARE Rs.10.060 THEN THE MARGINAL COST WILL BE 10,060 10,000 = 60

EXAMPLE OF DIFFERENT COST

QUANTITY FIXED COST VARIABLE C TOT. COST MARGINAL C AVERAGE C AVERAGE FC AVERAGE VC

0
55 0 55

1
55 30 85 30 85 55 30

2
55 55 110 25 55 27.5 27.5

3
55 75 130 20 43.5 18.3 25

4
55 105 160 30 40

5
55 155 210 50 42

6
55 225 280 70 46.3 9.17 37.5

13.75 11 26.25 31

TOTAL FIXED AND VARIABLE COST

C O 400 300

200
100

TC VC

FC 0 1 2 3 QUANTITY 4 5 6 7

MARGINAL COST CURVE

C O 50 45 40 35 30 25 20

MC

AC
AVC

S
T

1 2 3 4 QUANTITY

OTHER TYPES OF COSTS

NOMINAL OR MONEY COST: TI IS COST WHICH IS ENTERED IN THE BOOKS OF ACCOUNTS. IT IS ALSO CALLED EXPANSE OF PRODUCTION. REAL COST: IT IS COST WHICH INCLUDES COST OF EFFORT APART FROM NOMINAL COST.

OTHER TYPES OF COSTS

ECONOMIC COST: THIS COST INCLUDE OR EXCLUDE THE SUBSIDIES FROM MONEY COSTS. OPPORTUNITY COST: IT IS THE COST OF SACRIFICING THE NEXT ALTERNATIVE.

RELATIONSHIP BETWEEN PRODUCTION AND COST

BY THE PREVIOUS DISCUSSION WE KNOW THAT PRICE OF INPUTS ARE IMPORTANT FACTORS INFLUENCING COST. WE ALSO KNOW THAT COST CURVE ALSO DEPENDS VERY CLOSELY ON THE FIRMS PRODUCTION FUNCTION. IN OTHER WORDS FIRM CAN GET MORE OUTPUT WITH SAME INPUT IF THEY CAN UTILIZE THE PRODUCTIVITY CONCEPTS OR USE THE TECHNOLOGICAL IMPROVEMENT IN THEIR PROCESS.

RELATIONSHIP BETWEEN PRODUCTION AND COST

THE FIRM CAN CALCULATE THE LEAST COST COMBINATION OF INPUTS. FOR THIS PURPOSE WE CAN CALCULATE THE TOTAL COST OF THE LEAST COSTLY BUNDLE OF INPUTS. WHEN WE DO THAT FOR EVERY POSSIBLE LEVEL OF OUTPUT. FOR EXAMPLE A FARMER RENT 10 ACRES OF LAND WHICH COSTS 5.5 PER ACRE AND LABOR COST 5 PER WORKERS. IN THIS EXAMPLE LAND COST IS FIXED AS IT IS LEASED FOR 10 YEARS AND LABOR COST IS VARIABLE.

RELATIONSHIP BETWEEN PRODUCTION AND COST

OUTPUT TONS

0 10
0

1 10
6

2 10
11

3 10
15

4 10
21

5 10
31

6 10
45

7 10
63

8 10
85

LAND INPUT
LABOR INPUT

LAND RENT LABOR WAGES

TOTAL COST

5.5 5.5 5.5 5.5 5 55 5 85 5 5

5.5 5.5 5.5 5.5 5.5 5 5 5 5 5

110 130 160 210 280 370 480

RELATIONSHIP BETWEEN PRODUCTION AND COST

THE RELATIONSHIP BETWEEN COST AND PRODUCTION HELPS US TO EXPLAIN WHY AVERAGE COST CURVES TEND TO BE U SHAPED. THE ANALYSIS CAN BE DONE ONE SHORT TERM AND LONG TERMS BASIS.

RELATIONSHIP BETWEEN PRODUCTION AND COST

IN SHORT TERM, THAT IS FOR SHORT PERIOD OF TIME, IT IS NOT ENOUGH FOR THE FIRM TO ADJUST VARIABLE INPUTS, SUCH AS LABOR. FURTHERMORE THE FIXED OVERHEAD FACTORS SUCH AS PLANT AND MACHINERY CANNOT BE FULLY MODIFIED OR ADJUSTED. THEREFORE IN SHORT RUN, TYPICALLY LABOR AND MATERIALS COST ARE VARIABLE COSTS WHILE CAPITAL COST ARE FIXED.

RELATIONSHIP BETWEEN PRODUCTION AND COST

IN THE LONG RUN, ALL INPUTS CAN BE ADJUSTED, INCLUDING LABOR, MATERIALS AND CAPITAL. HENCE, IN THE LONG RUN, ALL COSTS ARE VARIABLE AND NONE ARE FIXED. WE CAN SUMMARIZE THE RELATIONSHIP BETWEEN THE PRODUCTION LAWS AND THE COST CURVES AND FOLLOWS:

RELATIONSHIP BETWEEN PRODUCTION AND COST

IN THE SHORT RUN, WHEN FACTORS SUCH AS CAPITAL ARE FIXED, VARIABLE FACTORS TEND TO SHOW AN INITIAL PHASE OF INCREASING RETURN FOLLOWED BY CONSTANT RETURN AND THEN DECREASING RETURN. THE CORRESPONDING COST CURVES ALSO SHOW AN INITIAL PHASE OF DECKLING MERGING FOLLOWED BE CONSTANT COST AND THEN INCREASING MARGINAL COST.

CHOICE OF INPUTS BY THE FIRM

EVERY FIRM MUST DECIDE HOW TO PRODUCE ITS OUTPUT. SHOULD ELECTRICITY BE PRODUCED BY OIL OR GAS OR FROM COAL. SHOULD CLASSES BY THOUGHT BY PERMANENT FACILITY OR WITH PART TIME FACILITY. THIS IS THE COMPLETION OF LINK BETWEEN PRODUCTION AND COST BY USING MARGINAL PRODUCT CONCEPT TO ILLUSTRATE HOW FIRM SELECT THE LEAST COST COMBINATION OF INPUTS.

CHOICE OF INPUTS BY THE FIRM

SAY A FIRMS ENGINEER HAS CALCULATED THAT THE DESIRED OUTPUT LEVEL OF 9 UNITS COULD BE PRODUCED WITH TWO POSSIBLE OPTIONS. IN BOTH CASES ENERGY WILL COST (E) Rs.2 PER UNIT AND LABOR COST (L) WILL BE Rs.5 PER HOUR. THE TWO OPTION WILL BE:
OPTION E L E COST L COST T. COST

1 2

10 4

2 5

20 8

10 25

30 33

CHOICE OF INPUTS BY THE FIRM

WHICH COMBINATION IS BEST, OBVIOUSLY OPTION 2 WHICH HAS LEAST COST. GENERALLY, THERE ARE USUALLY MANY POSSIBLE INPUT COMBINATIONS, NOT JUST TWO, BUT WE DON NOT HAVE TO CALCULATE THE COST FOR EVERY COMBINATION. IN ORDER TO FIND OUT THE LEAST COST COMBINATION

CHOICE OF INPUTS BY THE FIRM

THE SIMPLE WAY IS TO CALCULATE THE MARGINAL PRODUCT OF EACH COMBINATION. THEN DIVIDE THE MARGINAL PRODUCT BY THE PRICE OF THAT INPUT. THIS WILL GIVE US THE MARGINAL PRODUCT PER RUPEE OF INPUT. MARGINAL PRODUCT OF A = ----------------------------------------PRICE OF A MARGINAL PRODUCT OF B = ----------------------------------------PRICE OF B

ECONOMIES AND DISECONOMIES OF SCALE

THE TERM ECONOMIES OF SCALE IS DEFINED AS THE DECREASE IN THE UNIT COST OF PRODUCTION AS A FIRM INCREASES ALL ITS INPUTS OF PRODUCTION.

ECONOMIES OF SCALE

ECONOMIES AND DISECONOMIES OF SCALE

FIRM A HAS LOW CAPACITY WHERE AS FIRM B HAS HIGHER CAPACITY. FIRM B IS ABLE TO PRODUCE Q1 UNITS OF OUTPUT AT A UNIT COST WHICH IS LESS THAN THE UNIT COST OF FIRM A. IT SIGNIFIES THAT OVER A CERTAIN RANGE OF OUTPUT, THE LARGER PLANT IS ABLE TO PRODUCE GREATER AMOUNTS OF OUTPUT AT A LOWER AVERAGE COST THAN THE SMALLER ONE.

ECONOMIES OF SCALE
SOMETIMES ECONOMIES OF SCALE IS USED INTERCHANGEABLY WITH THE TERM INCREASING RETURNS TO SCALE. INCREASING RETURNS TO SCALE IS A LONG-TERM PHENOMENON* INDICATING THAT THE FIRMS OUTPUT GROWS AT A RATE THAT IS FASTER THAN THE GROWTH RATES OF ITS INPUTS. FOR EXAMPLE, A 100 PERCENT INCREASE IN INPUTS RESULTS IN MORE THAN 100 PERCENT INCREASE IN OUTPUT, SAY 200 PERCENT.

REASONS FOR ECONOMIES OF SCALE

1. SPECIALIZATION IN THE USE OF LABOR AND CAPITAL 2. INDIVISIBLE NATURE OF MANY TYPES OF CAPITAL EQUIPMENT 3. PRODUCTIVE CAPACITY OF CAPITAL EQUIPMENT RISES FASTER THAN PURCHASE PRICE 4. ECONOMIES IN MAINTAINING INVENTORY OF REPLACEMENT PARTS AND MAINTENANCE PERSONNEL

REASONS FOR ECONOMIES OF SCALE

5. DISCOUNTS FROM BULK PURCHASES 6. LOWER COST OF RAISING CAPITAL FUNDS 7. SPREADING OF PROMOTIONAL AND RESEARCH-AND-DEVELOPMENT COSTS 8. MANAGEMENT EFFICIENCIES (LINE AND STAFF)

REASONS FOR DISECONOMIES OF SCALE

1. DISPROPORTIONATE RISE IN TRANSPORTATION COSTS 2. INPUT MARKET IMPERFECTIONS (E.G., WAGE RATES DRIVEN UP) 3. MANAGEMENT COORDINATION AND CONTROL PROBLEMS 4. DISPROPORTIONATE RISE IN STAFF AND INDIRECT LABOR

ECONOMIES AND DISECONOMIES OF RETURN