Chapter V

Production & Cost

Analysis
Dr. GOPALAKRISHNA B.V.
Faculty in MBA,
SDM, Mangalore
• Production is the creation of goods &
services by organising land, labour
& capital.
• The aim of production is supply of
goods & services for consumption.
• So production is the act of creating
utility or value.
• It conversion of inputs into output –
i.e., transforming physical input
into physical output.
• Law of production are explained in
connection with production
functions. A production function
explains the relationship between
factors of production (physical
 Definition of production function
• G.J. Stigler – the production function is
the name given to the relationship
between the rate of input of productive
services & the rate of output of product.
• Prof Leontief – a production function is
the name given to the relationship
between the rate of input of productive
services & the rate of output of product.
It is the economist’s summary of
technological knowledge.
• Prof Watson – production means the
transformation of inputs into outputs.
The production function is the name for
the relation between the physical inputs
and physical outputs of a firm. If a small
factory produces hundred wooden chairs
per eight hour shift, then its production
function consists of the minimum
quantities of wood, glue, varnish, labour
time, machine time, floor space,
• Thus a production function explains the
functional relationship between physical
inputs & physical outputs of firms.
• Algebrically, the production function can
be expressed in equation in which the
inputs are independent & output are
dependent variable.
• The common equation denoting a simple
production function is the following ways
–
• Q = f (L, N, K)
 Q = physical output
 f = functional relationship
 L = land
 N= labour units
 K = capital employed
 Production Function

Production
Inputs
Function Output
(L, K)
q = f(L, K) q
 Algebrical expression
•
Q = f (a, b, c, d …..n)
• Q = stands fro the rate of output of
given commodity.
• A, b, c, d ….n are different factors
and services
• f = functional relationship
 Production function depends on

1.Quantities of resources (raw-

materials, labourers, capital,
machinery etc).
2.State of technology is given.
3.Possible processes.
4.Size of the firms.
5.Nature of firms organization and
6.Relative price of inputs and the
manner in which the inputs are
combined.
 Production function

 In economic theory, there are three

types of production function, they
are –
1.Production function with one variable
input – The Law of Variable
Proportions
2.Production function with two variable
input – Iso-quant curves
3.Production function with all variable
input – Law of Returns to scale
  Production function with one
variable input
• Production function with one variable
input are also called as law of
variable proportions.
• This law occupies an important place
in economic theory.
• The law states a technical physical
relationship between the fixed and
variable factors of production in
the short run.
• Here it is assumed that only one
factor of production is a variable
factor (labour) while other factor are
 Assumptions of the law
1.The state of technology is assumed to be
given and unchanged.
2.Only one factor is varied (labour) and all
other factors remain unchanged
(land, capital, equipment and raw-
material etc).
3.The fixed factor and the variable factor are
combined together in various
proportions in the process of production.
4.The units of the variable factors are
homogeneous.
5.The law operates in the short-run.
 Table 5.1 Returns to Labour
Un it s o f To t a l P ro d u c t Ma rg in a l Av e ra g e
La b o u r ( q u in t a ls ) P ro d u c t P ro d u c t s
( q u in t a ls ) ( q u in t a ls )

1 80 80 80
2 170 90 85
3 270 100 90
4 368 98 92
5 430 62 86
6 480 50 80
7 504 24 72
8 504 00 63
9 495 -9 55
10 480 -15 48
Average and Marginal Product
Curves
TP
Total Product

AP max &
AP = MP
MP max
L
Point of diminishing
AP marginal returns
MP Point of diminishing
average returns
AP
MP
L’ L” L
 Production with
One Variable Input (Labor)
Outpu
t Observations:
per Left of E: MP > AP & AP is increasing
Month Right of E: MP < AP & AP is decreasing
E: MP = AP & AP is at its maximum

30
Marginal Product

E Average Product
20

10

0 1 2 3 4 5 6 7 8 9 10 Labor per Month

 60
50
Stage I Stage II Stage III
40
30
20
10
0
15 0 2 4 6 8 10

10

0
0 2 4 6 8 10
-5
 Three stages of the law of variable
proportion
 Stage I
• Total product will increases at an increasing rate.
• Average and marginal product also increase but
marginal product rises at a faster rate than
average product.


Stage II
• Total product continues to increase but at a
diminishing rate
• Marginal product is diminishing and becomes
equal to zero
• Average product starts diminishing


 Stage III
• Total product starts declining
• Marginal product becomes negative
 Table 5.2 Behaviour of TP, MP and AP during
three stages of production
Different Total Product Marginal Product Average Product
Stages (TP) (MP) (AP)

Increases, reaches its

Stage I Increases at an maximum and then Increases and
increasing rate declines till MR = AP reaches its
maximum
Increases at a It diminishing and
Stage II diminishing rate becomes equal to zero Starts declining
till it reaches
maximum

Stage III Starts declining Become negative Continues to

decline

2. Production Function with
two variable inputs
• To understand a production function with
two variable inputs, it is necessary to
understand isoquant curve.
• An isoquant is also known as isoproduct
curve, which are similar to
indifference curves analysis.
• Isoquants are curves which represent the
different combinations of two
factors of production which are
capable of producing the same level
of output
 Labour and capital inputs in
relation to output
Factor Labour Capital Units of
combination production
A 1 5 10
B 2 3 10

C 3 2 10

D 4 1 10
E 5 0 10
 IQ
y

Iso - quant Curve

5 A
Capital

3 B

2 C
D
1
IQ

0 1 2 3 4 x
Labour
• All those input combinations which
are capable of producing the same
level of output.
• Isoquants are thus contour lines
which trace the loci of equal
outputs.
• Since an isoquant represents those
combinations of inputs which will
be capable of producing an equal
quantity of output.
• Therefore, it is also called as
production-indifference curve.
 Types of Isoquants
 1. Liner isoquants
• There is perfect substitutability of inputs.
• For example – a given output say 100 units can
be produced by using only capital or labour or
combination of both labour and capital.


Units of outputs Labor Capital


100 1 5 A
100 2 3 B

Capital
100 3 2
100 4 1
C

Labour
 2. Right angle isoquant
• There is complete non-substitutability between
the inputs.
• This is also known as Leontief isoquant or input-
outputY isoquant.


Q3
Capital

Q2

Q1

O X
Labour
 3. Convex of isoquant curve

This form assumes substitutability of inputs but the

substitutability is not perfect.
IQ
y

Iso - quant Curve

12 A
Capital

8 B

5 C
D
3
IQ

0 1 2 3 4 x
Labour
  Properties of isoquants


1.Isoquants slope downward from left to

right
2.Isoquants are convex to the origin
3.Isoquants can neither touch nor intersect
each other
4.Isoquants need not be parallel to each
other, they may be parallel, they may
not be parallel.
5.The higher isoquant shows the higher level
of production.
 Properties of Isoquants
1. Isoquants slope downward from
left to right
 When the quantity of one factor
(labour) increased, the quantity of
other capital must be reduced so as
to keep output constant on a given
isoquant.
2. No two isoquants can interest

each other
 Isoquant curve never cut each
other as higher and lower curves
show different levels of satisfaction.
 Properties of Isoquants……
 3. Isoquants curve are convex to
the Origin
§ Iso-quant curve as similar to indifference
curves are convex to the origin and they
cannot be concave to the Origin.
§ The marginal rate of technical substitution
are normally convex to the origin and it
cannot be concave.
§ If the isoquants were concave to the origin
– marginal rate of technical substitution
increased as more and more units of
labour are substituted for capital
 IQ
y

Iso - quant Curve

12 A
Capital

8 B

5 C
D
3
IQ

0 1 2 3 4 x
Labour
 Y

Capital IQ 1

IQ 2

O X
Labour
Marginal Rate of Technical Substitution

• The Marginal Rate of Technical

Substitution (MRTS) production theory
is similar to the concept of Marginal
Rate of Substitution of Indifference
curve analysis.
• MRTS - indicates the rate at which factors
can be substituted at the margin without
altering the level of output
• MRTS of labour for capital - defined as one
number of units of capital which can be
replaced by one unit of labour, the level
of output remaining unchanged..
 Marginal Rate of Technical
Substitution
Factor Units of Units of MRTS of
Combination Labour (L) Capital (K) L for K
A 1 12 -

B 2 8 4:1

C 3 5 3:1

D 4 3 2:1

E 5 2 1:1
 IQ
y

Iso - quant Curve

12 A
Capital

8 B

5 C
D
3
IQ

0 1 2 3 4 x
Labour
 3. Production function with all variable input –
law of returns to scale
§ The law of returns to scale describes the
relationship between outputs & scale
of inputs in the long run.
§ When all the inputs are increased in the same
proportion output increased by different
proportion – increasing return, constant
return & diminishing return.
§ Prof Roger Miller – defined returns to scale
refers to the relationship between
changes in output & proportionate
changes in all factors of production.
§ In the long run, due to change in demand, the
firm increases its scale of production by
using more space, more machines &
labourers in the factory.
§ In the long run all factors of production are
variable – no factor is fixed – all the
factors treated as variable factors.
§ Accordingly, the scale of production can
be changed by changing the
quantity of all factors of production.
§ It all factors of production is doubled, the
total output will also be doubled.
§ According to this law, when all factor units
are increased, total product generally
increases at an increasing rate, later at a
constant rate and finally decreasing rate.
§
 Returns to Scale

Increasing Constant Decreasing

Returns Returns Returns

Assumptions of law of returns to

scale
1. All factors are variable but enterprise
is fixed.
2. A worker works with given tools &
implements.
3. Technological changes are absent.
4. There is perfect competition.


 1. Increasing Returns to Scale

§ If the increase in all factors leads to more than
proportionate increase in output – increasing
returns to scale.
§ Thus, if all factors are doubled & output increases
by more than double then the returns to scale
are increasing.
§ For example – all inputs are increases by 25% &
output increases by 40% then the increasing
returns to scale will be prevailing.
§ This increase is due to many reasons like division
of labour, specialisation and other external
economies of scale.

Increasing returns to scale

Units of Total Marginal

variable Product Product
inputs
1 20 20
2 60 40
3 120 60
4 200 80 Y

IRS

Productivity

O X

No. units of labour and capital

 2. Constant Returns to Scale
§ If we increase all factors of production a
given proportion & the output increases
in the same proportion – constant
returns to scale
§ In simple terms, if factors of production
are doubled output will also be doubled.
§ In this case internal & external economies
are exactly equal to internal economies
& external diseconomies
§ This is also known as Homogeneous
Production Function or Cobb-Douglas
Linear homogeneous production function
 Constant returns to
scale
Units of Total Marginal
variable
1 Product
20 Product
20
inputs
2 40 20
3 60 20
4 80 20

CRS

O X
 3. Diminishing Returns to Scale
§ If the increase in all factors leads to a
less than proportionate increase in
output – diminishing returns to
scale
§ When a firm goes on expanding all its
inputs, then eventually diminishing
returns to scale will be occur.
Diminishing returns to scale

Units of Total Marginal

variable Product Product
inputs
1 60 60
2 100 40
3 120 20
4 120 00
5 100 -20
6 60 -40
Y

Productivity

DRS

O No. units of labour and capital X

 Y

Returns to scale

Constant
Di
m in
is
ng

hi
si

ng
ea
cr
In

O X
Scale of
production
Returns to Scale
§ Total product (TP) – total physical
product refers to the total output of
a commodity produced by the
combination of fixed factors and
variable factor.
§ Average product (AP) – it is
calculated by dividing the total
output by the number of fixed &
variable inputs used.
§ Marginal product (MP) – refers to
the additional output i.e., addition
to the total output from the use of
an additional factor.
 A B C

D
Productivity

R
C

R
I

Units of labour & capital

  Cost analysis & cost function
§ The relationship between cost & output is
known as the cost function.
§ Cost play a very significant role in
managerial decisions involving a
selection between alternative course of
action.
§ Costs enter into almost every business
decision & it is important to use the right
analysis of cost.
§ Price determination of a commodity with
the help of demand & supply factors,
where as price of commodity influenced
by cost of production.
 

§ Cost of production means the actual

expenditure incurred for acquiring
or producing a goods or service.
§ Cost of production directly influences
on production function as well as
the price determination of a
commodity.
 Types of costs of production
1. Money cost & real cost
2. Implicit cost & explicit cost
3. Short run cost & long run cost
4. Total cost, marginal cost & average
cost
 1. Money cost & real cost
§ Money cost are also called as nominal
cost. The money cost refers to total
money expenses incurred by a firm
in producing a commodity.
§ It includes – cost of raw-material,
wages & salaries of labour,
expenditure on machinery &
equipment, depreciation on
machines, building & such other
capital goods, advertisement
expenditure etc.
§ Real cost is a subjective concept. It
expresses the pains & sacrifices
involved in producing a commodity.
§ Marshal, argues that real cost of
production of a commodity is expressed
 2. Implicit cost & explicit cost
§ Implicit cost are the imputed value of the
entrepreneur’s own resources &
services.
§ In other words, implicit costs are costs
which self-owned & self-employed
resources could have earned in their
best alternative uses.
§ Explicit cost are those costs which are
actually paid by the firm.
§ Explicit cost include wages & salaries,
prices of raw-materials, amounts paid on
fuel, power, advertisement,
transportation, taxes & depreciation
charges.
 3. Short run cost & long run costs
§ Short run is a period in which a firm
cannot change its plant, its
equipment & the scale of production.
§ In short period, a firm can increase its
output only by varying the amount of
variable factors such as labour &
capital.
§ In the short period, two types of cost
existed fixed cost & variable cost.
§ Fixed costs are the costs for fixed
inputs/factors such as land - building
machinery and tools etc.
§ Variable costs are the costs for the
variable factors like prices of raw-
materials, prices of electricity, water
and wages & salaries for the labours.
 Short run costs

Short run Short run Short run

total cost average cost marginal cost

Average Average
Total fixed Total variable
fixed cost Variable
cost cost
cost
 1. Short run total cost
§ Short run total cost refers to the overall
expenses made by the firm in order to
produce a commodity at given output.
§ Short run total cost consists total fixed
cost (TFC) & total variable cost (TVC).
§ Therefore, it expressed in terms of TC =
TFC + TVC.
§ Total fixed cost – related to the expenses
incurred for fixed factor such as capital,
machinery, land, management etc.
§ Total fixed cost remains the same,
whatever be the level of output.
§ Even no production, firm incurring
some cost such as salaries for
security guards, rent for land &
building, electricity charges and
water charges etc.
§ Total variable cost (TVC) – vary
with the level of output. These
costs are incurred on the
employment of variable factors of
production such as labour, raw-
materials.
§ They are incurred when the factory is
at work.
§ The TVC will incurs with the increase
 Y
Cost

TFC

O X
Output
 Short run variable costs

Short run
variable cost

O X
output
 2, Short run average cost
§ Average cost is the cost per unit of output
produced. It is cost per unit of output produced.
§ Average cost per unit of output is the total cost
divided by the number of units produced.
§ STC C
SAC = =
§
No unit produced X
§
§
§ Short run average cost has two types average fixed cost &
average variable cost.

 average fixed cost (AFC)
§ Average fixed cost is nothing but average
cost which is obtained by dividing the
total cost by the quantity produced.
§ AFC = total fixed cost= TFC
 total output X


 Average variable cost

§ Average variable cost is the total variable
cost divided by the number of units
produced.
§ It is calculated by using the following
formula
AVC =
TVC

 Output
  Cost analysis & cost function
§ The relationship between cost &
output is known as the cost
function.
§ Cost play a very significant role in
managerial decisions involving a
selection between alternative
course of action.
§ Costs enter into almost every
business decision & it is important
to use the right analysis of cost.
§ Price determination of a commodity
with the help of demand & supply
factors, where as price of
 

§ Cost of production means the actual

expenditure incurred for acquiring
or producing a goods or service.
§ Cost of production directly influences
on production function as well as
the price determination of a
commodity.
 Types of costs of production
1. Money cost & real cost
2. Implicit cost & explicit cost
3. Short run cost & long run cost
4. Total cost, marginal cost & average
cost
 1. Money cost & real cost
§ Money cost are also called as nominal
cost. The money cost refers to total
money expenses incurred by a firm
in producing a commodity.
§ It includes – cost of raw-material,
wages & salaries of labour,
expenditure on machinery &
equipment, depreciation on
machines, building & such other
capital goods, advertisement
expenditure etc.
§ Real cost is a subjective concept. It
expresses the pains & sacrifices
involved in producing a commodity.
§ Marshal, argues that real cost of
production of a commodity is expressed
 2. Implicit cost & explicit cost
§ Implicit cost are the imputed value of the
entrepreneur’s own resources &
services.
§ In other words, implicit costs are costs
which self-owned & self-employed
resources could have earned in their
best alternative uses.
§ Explicit cost are those costs which are
actually paid by the firm.
§ Explicit cost include wages & salaries,
prices of raw-materials, amounts paid on
fuel, power, advertisement,
transportation, taxes & depreciation
charges.
 3. Short run cost & long run costs
§ Short run is a period in which a firm
cannot change its plant, its
equipment & the scale of production.
§ In short period, a firm can increase its
output only by varying the amount of
variable factors such as labour &
capital.
§ In the short period, two types of cost
existed fixed cost & variable cost.
§ Fixed costs are the costs for fixed
inputs/factors such as land - building
machinery and tools etc.
§ Variable costs are the costs for the
variable factors like prices of raw-
materials, prices of electricity, water
and wages & salaries for the labours.
 Short run costs

Short run Short run Short run

total cost average cost marginal cost

Average Average
Total fixed Total variable
fixed cost Variable
cost cost
cost
 1. Short run total cost
§ Short run total cost refers to the overall
expenses made by the firm in order to
produce a commodity at given output.
§ Short run total cost consists total fixed
cost (TFC) & total variable cost (TVC).
§ Therefore, it expressed in terms of TC =
TFC + TVC.
§ Total fixed cost – related to the expenses
incurred for fixed factor such as capital,
machinery, land, management etc.
§ Total fixed cost remains the same,
whatever be the level of output.
§ Even no production, firm incurring
some cost such as salaries for
security guards, rent for land &
building, electricity charges and
water charges etc.
§ Total variable cost (TVC) – vary
with the level of output. These
costs are incurred on the
employment of variable factors of
production such as labour, raw-
materials.
§ They are incurred when the factory is
at work.
§ The TVC will incurs with the increase
 Y
Cost

TFC

O X
Output
 Short run variable costs

Short run
variable cost

O X
output
 2, Short run average cost
§ Average cost is the cost per unit of output
produced. It is cost per unit of output produced.
§ Average cost per unit of output is the total cost
divided by the number of units produced.
§ STC C
SAC = =
§
No unit produced X
§
§
§ Short run average cost has two types average fixed cost &
average variable cost.

 average fixed cost (AFC)
§ Average fixed cost is nothing but average
cost which is obtained by dividing the
total cost by the quantity produced.
§ AFC = total fixed cost= TFC
 total output X


 Average variable cost

§ Average variable cost is the total variable
cost divided by the number of units
produced.
§ It is calculated by using the following
formula
AVC =
TVC

 Output
Average cost = AFC + AVC
 3. Marginal cost
• Marginal cost is an addition to the
total cost caused by producing one
more unit of output.
Change in TC
• Marginal cost =
Change in output


MC = TC
q
  Long run cost


§ The long run is a period in which a firm

can change its plant, equipment & the
scale of production.
§ It is a period which is sufficiently long
enough to bring about changes in all the
factors of production.
§ Thus, in the long run all the factors of
production are variable.
§ There is no classification of costs in the
long run as fixed & variable as in the
short period.
§ In the long run machinery, land,
equipment can be changes due to
 Long run cost

Long run Long run Long run

total cost average cost marginal cost
 Long run total cost
Long run total cost is always less than or

equal to short run total cost, but it is never

more than short run total cost
Long run average cost

§ The long run average cost is the long run

totalLTC
cost divided by the level of output
§ LAC = Q
Long run marginal cost

§ Long run marginal cost shows the change

in total cost
TC
due to the production of one
more unit of commodity.
Q
 LMC =
 LTC 1
LTC 2
cost

LTC 3

Output

Economies of Scale
• In modern days, the size of the business
undertakings has greately increased &
production on a large scale is a very
important feature of modern industrial
society.
• Large-scale production offers certain
advantages which help in reducing the cost
of production.
• It is a common experience of every producer
that costs can be reduced by increased
production. That is why the producers are
more keen on expanding the size/scale of
production.
• Economies of scale have been classified by
Marshall into – internal and external
 Economies of Scale

Internal External Economies

Economies
 External
Internal Economies Economies
Technical
Economies

Managerial Economies
Economies of
concentrati
Labour Economies on

Financial
Economies Economies
of
information
Marketing
Economies
Economies
Economies of R of
& D disintegrat
ion
Economies of
Welfare
Risk Spreading
Economies

Internal Economies
• Internal economies - are those
economies production which accrue to
the firm when it expands the output, so
that the cost of production would come
down considerably and place the firm in
a better position to compete in the
market effectively.
• Economies arise purely due to
endogenous factors relating to
efficiency of the entrepreneur or his
managerial talents the marketing
strategy adopted.
• Basically, internal economies are those
which are special to each firm. These
solely depend on the size of firm and will
be different for different firms.
 1. Technical Economies
§ Technical economies pertain not to the size of
the firm but to the size of the factory.
§ Technical economies are those which accrue to a
firm from the use of better machines and
techniques of production.
§ As a result, production increases and cost per unit
of production decreases.
 2. Managerial Economies
§ The advantages derived from the efficient
management are called managerial
economies.
§ Usually efficiency of the management increases
with an increase in the size of the firm.
§ A large firm can divide its big departments into
various sub-departments and each
department such as finance, marketing,
recruitment, training, finance, welfare,
legal, administration , sales etc.
 3. Labour Economies
§ Under large scale production there will be scope
for division of labour & specialisation.
(skilled & unskilled labours)
§ Expansion of the scale of production of the firm
reduces the labour cost through proper division
of labour.
§ There will be overall development (both the
efficiency & productivity of labour) which will
result in reducing cost.
 4. Financial Economies
§ When compared to the smaller firms, longer funds
are available to the large firms & hence they
reap financial economies.
§ They can borrow from banks or any other
financial institution.
§ They can also raise capital through the sale of
shares & debentures to the public.
 5. Marketing Economies
• Economies are achieved by a large firm
both in buying raw-materials & also
in selling its finished products.
• A large firm can generally buy more
cheaply than a small one, because it
can purchase its raw-materials on a
large scale at a low cost.
• Similarly, on the sales side also, a big
firm can reap advantages of large
scale marketing.
• Selling is generally less expensive per
unit when large quantities are
distributed, because a selling
organisation should be an optimum size
 6. Economies of R & D
§ A large sized firm can spend more
money on its research activities
(R & D).
§ They can spend hug sum money in
order to innovate new varieties of
products or improve the quality of
the existing products.
§ New innovations/new methods of
producing a product may help to
reduce its average cost.
§ In cases of innovation it will become
an asset of the firm.
 7. Economies of welfare
§ A large firm can provide welfare facilities
to its employees such as subsidising
housing, subsidised canteens, crèches
for the infants of women workers,
recreation facilities etc.
§ All these measures have an indirect effect
on increasing production & at reducing
the cost.
 8. Risk bearing Economies
§ The big firms always involved risk-bearing.
§ A big firm produces a large number of
items and of different varieties so that
the loss in one can be counter balanced
by the gain in another.
§ A large firm can avoid risk such as
diversification of output,

External Economies
§ External economies refers to all those
benefits which accrue to all the firms
operating in a given industry.
§ External economies can be enjoyed by all
the firms in the industry irrespective of
their size.
§ The emergence of external economies is
due to localisation.
§ According to Cairncross – “External
economies are those benefits which are
shared in by a number of
firms/industries when the scale of
production in any industry increases”.
 External Economies

Economies of Economies of Economies of

concentration disintegration information
 1. Economies of Concentration
§ When a number of firms are located in one place,
all the member of firm reap some common
economies.
§ As the number of firms in an area increases each
firm enjoys some benefits like, transport and
communication, availability of raw-materials,
research and invention etc.
§ Financial assistance from banks and non-bank
institutions easily accrue to firm.
§ It is easy to make arrangements for repairs
maintenance & special services required by an
industry when the firm located.
§ And even larger firms located in one particular
locality not only increased quantity of goods &
services but also reduced cost of production.
§ Concentration of firms in a definite locality
increases the competition among therein and

2. Economies of Information
§ When the number of firms in an industry
expands they become mutually dependent on
each other – they do not feel the need of
independent research on individual basis.
§ The information regarding research &
development, trading activities & other are
information obtained from published in
bulletins & journals.
§ Such information provides knowledge about
modern development in business world,
modern technology, inventions & innovations,
market trends & the like.
§ It is easy to establish a common information
bureau when the firms are concentrated in a
locality.
§ Some times the government bears the cost of
information & research services & benefits are
shared by the industries.
 3. Economies of Disintegration
• When the industry grows, it becomes
possible to split up production into
several processes & leave some of the
processes to be carried out more
efficiently by specialised firms.
• This makes specialisation possible &
profitable. For example – cotton Textile
Industry – some firms may specialise in
manufacturing thread, some others in
producing dhoties, some in knitting
banians some in weaving sarees etc.
• The disintegration may be horizontal or
vertical. Both will help the industry in
avoiding duplication and saving time
materials.

External Economies


§ External economies refers to all those

benefits which accrue to all the firms
operating in a given industry.
§ External economies can be enjoyed by all
the firms in the industry irrespective of
their size.
§ The emergence of external economies is
due to localisation.
§ According to Cairncross – “External
economies are those benefits which are
shared in by a number of
firms/industries when the scale of
production in any industry increases”.
 External Economies

Economies of Economies of Economies of

concentration disintegration information
 1. Economies of Concentration
§ When a number of firms are located in one place,
all the member of firm reap some common
economies.
§ As the number of firms in an area increases each
firm enjoys some benefits like, transport and
communication, availability of raw-materials,
research and invention etc.
§ Financial assistance from banks and non-bank
institutions easily accrue to firm.
§ It is easy to make arrangements for repairs
maintenance & special services required by an
industry when the firm located.
§ And even larger firms located in one particular
locality not only increased quantity of goods &
services but also reduced cost of production.
§ Concentration of firms in a definite locality
increases the competition among therein and

2. Economies of Information
§ When the number of firms in an industry
expands they become mutually dependent on
each other – they do not feel the need of
independent research on individual basis.
§ The information regarding research &
development, trading activities & other are
information obtained from published in
bulletins & journals.
§ Such information provides knowledge about
modern development in business world,
modern technology, inventions & innovations,
market trends & the like.
§ It is easy to establish a common information
bureau when the firms are concentrated in a
locality.
§ Some times the government bears the cost of
information & research services & benefits are
shared by the industries.
 3. Economies of Disintegration
• When the industry grows, it becomes
possible to split up production into
several processes & leave some of the
processes to be carried out more
efficiently by specialised firms.
• This makes specialisation possible &
profitable. For example – cotton Textile
Industry – some firms may specialise in
manufacturing thread, some others in
producing dhoties, some in knitting
banians some in weaving sarees etc.
• The disintegration may be horizontal or
vertical. Both will help the industry in
avoiding duplication and saving time
materials.
  Dis - economies of scale
§ Though there are a good number of
advantages in the large scale
production, it is not free from some
limitation which is called
diseconomies of scale.
§ Just like economies of scale
diseconomies o scale are also
classified into – internal and
external diseconomies
 Diseconomies of Scale

Internal External
Diseconomies Diseconomies
Internal Diseconomies of Scale

Difficulties of Management

Problems of Co-ordination

Increased Risks

Labour diseconomies

Financial
difficulties

Marketing diseconomies

Scarcity of factor supplies

 1. Difficulties of Management
§ As a firm expands, complexities & problems of
management increases
§ The entrepreneur & management will not be able
to maintain contact with each other & check on
all the department a very large concern.
§ The problem of supervision will be there.
§ For the defects in organisation will lead to wastes
of resources & increasing average cost.
 2. Problems of Co-ordination
§ The task of organisation & co-ordination become
more & more difficult with the increasing size of
the firm.
§ The management of the firm will gradually face
numerous problems of decision-making &
organisation.
§ Decisions taken in a hurry result in inefficiency &
 3. Increased risks
§ As the scale of production increases,
investment also increases, so too the
risks of business.
§ The large the output, obviously the greater
will be the loss form an error of
judgment or misfortune in business.
 4. Labour diseconomies
§ Labour diseconomies may also arise with
the growing scale of output.
§ It may result in lack of initiative &
industrial disputes leading to increase in
cost of production.
 5. Financial difficulties
§ A big concern needs huge capital which
cannot always be easily obtained.
§ Hence, the difficulty in obtaining sufficient
capital frequently prevents the further
expansion of such firms.
 6. Marketing diseconomies
§ When the industry expands & the firm
grows, competition in the market tends
to become stiff.
§ Thus, firms under monopolistic
competition will have to undertake
extensive advertising & sales promotion
efforts & expenditure which ultimately
 7. Scarcity of factor supplies
§ Due to the increase in the concentration of
firms in a particular locality, each firm
will find it difficult to get factor supplies
regularly & adequately.
§ There will also be the problems of
increased factor prices.
 8. Over production
§ There is every possibility in big business
that production may exceed the
requirements.
§ This resulting in over production.
§ It is very difficult to dispose off a large
output profitably.
 9. Difficulties in Decision – making
§ A larger firm may find it very difficult to
make a quick & correct decision.
External Diseconomies

Environmental Pollution

Resources get depleted

Increase price of factor inputs

Cost of living increases

Inadequate of basic facilities

Growth of towns - crimes

  External diseconomies
1.There will be the problem of –
environmental pollution.
2.Precious resources may get
depleted
3.There will be increase in the
prices of factor inputs.
4.There will be a rise in the cost of
living
5.Basic facilities may be
inadequate