Theory of Production

Law of variable proportions

• 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.”
• The law of returns to scale explains the
proportional change in output with respect to
proportional change in inputs. In other words,
the law of returns to scale ...
 Production Function with two Variable
Inputs!
• The Laws of Returns to Scale: Production
Function with two Variable Inputs! ... If by
increasing two factors, say labour and capital,
in the same proportion, output increases in
exactly the same proportion, there are
constant returns to scale.
 Isoquants
• It defines for every combination of inputs to
the production process the maximum output
that can be produced. ...Isoquants, or
constant quantity curves, show all values of
inputs for which output is
constant. Isoquants are formally similar to the
indifference curves in the utility function
problems.
Economies of Sale
• Economies of scale is the competitive
advantage that large entities have over
smaller ones. The larger the business, non-
profit, or government, the lower its per-unit
costs. It can spread fixed costs, like
administration and real estate, over more
units of production.
 Types of Economies of Scale

• There are two main types of economies of

scale: internal and external. Internal
economies are, as the name implies, internal
to the company itself and controllable by
management. External economies are
supported by external factors. These factors
include the industry, geographic location, or
government.
 Internal Economies of Scale

• Internal economies result from the sheer size of

the company, no matter what industry it's in or
market it sells to. For example, large companies
have the ability to buy in bulk. This lowers the
cost per unit of the materials they need to make
their products. They can use the savings to
increase profits . Or, they can pass the savings to
consumers and compete on price. There are five
main types of internal economies of scale.
 1.Technical economies of scale
• Result from efficiencies in the production process itself.
Research shows that manufacturing costs fall 70-90
percent . every time the business doubles its output.
Larger companies can take advantage of more efficient
equipment. For example, data mining software allows the
firm to target profitable market niches. Large shipping
companies cut costs by using super-tankers. They can
use post-Panamax ships that carry as many as 16 trains.
Finally, large companies achieve technical economies of
scale because they learn by doing. They’re far ahead of
their smaller competition on the learning curve.
 2.Monopsony power is when a company buys so
much of a product that it can reduce its per unit costs.
For example, Wal-Mart's "everyday low prices" are
due to its huge buying power.
3.Managerial economies of scale occur when large
firms can afford specialists to manage specific areas of
the company. For example, a seasoned sales executive
has the skill and experience to get the big orders.
They demand a high salary, but they're worth it.
4. Financial economies of scale means the company has
cheaper access to capital . A larger company can get
funded from the stock market with an initial public
offering . Big firms have higher credit ratings. As a result,
they benefit from lower interest rates on their bonds.
5.Network economies of scale occur primarily in online
businesses. It costs almost nothing to support each
additional customer with existing infrastructure. So, any
revenue from the new customer is all profit for the
business. A great example is eBay. 
 External Economies of Scale

• A company has external economies of scale if it receives preferential

treatment because of its size. That's most often occurs with governments.
For example, most states reduce taxes to attract the largest companies that
provide the most jobs. Big real estate developers convince cities to build
roads to support their buildings. This saves the developers from paying
those costs. Large companies can also take advantage of joint research
with universities. This lowers research expenses for these companies.

• Small companies don't have the leverage to benefit from external

economies of scale. But they can band together. They can take advantage
of geographic economies of scale by clustering similar businesses in a small
area . For example, artist lofts, galleries, and restaurants benefit by being
together in a downtown art district.
 Economies of Scale Versus Economies of
Scope
•  
• Economies of scope occur when a company branches out into
multiple product lines. They benefit by combining complementary
business functions, product lines, or manufacturing processes. For
example, most newspapers diversified into similar product lines,
such as magazines and online news. This diversified their revenue
away from declining newspaper sales. Their advertising sales
teams could sell ads in all three product lines. 
• It's easy to confuse economies of scale with economies of scope,
because they are both found in larger companies. Just remember
that economies of scale apply to one product line. Economies of
scope refer to combining efficiencies from many product lines. 
Theory of costs
 Traditional theory
• In the traditional theory of the firm total
costs are split into two groups total fixed
costs and total variable costs:
• TC = TFC + TVC
 Money Theory of cost
• In economics, the cost-of-
production theory of value is the theory that
the price of an object or condition is
determined by the sum of the cost of the
resources that went into making it.
The cost can comprise any of the factors of
production (including labour, capital, or land)
and taxation.
 Short Run Average Cost Curve

• In the short run, the shape of the average total cost

curve (ATC) is U-shaped
• The, short run average cost curve falls in the
beginning, reaches a minimum and then begins to
rise. 
• The reasons for the average cost to fall in the
beginning of production are that the fixed factors of
a firm remain the same. The change only takes place
in the variable factors such as raw material, labor,
etc.
• When a firm fully utilizes its scale of operation
(plant size), the average cost is then at its
minimum. The firm is then operating to its
optimum capacity.
• If a firm in the short-run increases its level of
output with the same fixed plant; the
economies of that scale of production change
into diseconomies and the average cost then
begins to rise sharply.
 Long Run Average Cost Curve:

• In the long run, all costs of a firm are variable.

• The firm having time-period long enough can
build larger scale or type of plant to produce
the anticipated output. 
• The shape of the long run average cost
curve is also U-shaped but is flatter that the
short run curve
• If the anticipated rate of output is 200 units per unit of time, the firm will
choose the smallest plant It will build the scale of plant given by SAC 1 and
operate it at point A. This is because of the fact that at the output of 200
units, the cost per unit is lowest with the plant size 1 which is the smallest of
all the four plants. In case, the volume of sales expands to 400, units, the size
of the plant will be increased and the desired output will be attained by the
scale of plant represented by SAC2 at point B, If the anticipated output rate is
600 units, the firm will build the size of plant given by SAC 3 and operate it at
point C where the average cost is $26 and also the lowest The optimum
output of the firm is obtained at point C on the medium size plant SAC 3.
 
• If the anticipated output rate is 1000 per unit of time the firm would build
the scale of plant given by SAC5and operate it at point E. If we draw a tangent
to each of the short run cost curves, we get the long average cost (LAC) curve.
The LAC is U-shaped but is flatter than tile short run cost curves.
Mathematically expressed, the long-run average cost curve is the envelope of
the SAC curves.
• In this figure the long-run average cost curve of the firm is lowest at point C.
CM is the minimum cost at which optimum output OM can be, obtained.
 Revenue
• Revenue is the income a firm retains from
selling its products once it has paid indirect
tax, such as VAT. Revenue provides the income
which a firm needs to enable it to cover
its costs of production, and from which it can
derive a profit. Profit can be distributed to the
owners, or shareholders, or retained in the
business to purchase new capital assets or
upgrade the firm’s technology.
 Total revenue

• Total revenue (TR), is the total flow of income

to a firm from selling a given quantity of
output at a given price, less tax going to the
government. The value of TR is found by
multiplying price of the product by the
quantity sold.
 Average revenue

• Average revenue (AR), is revenue per unit, and

is found by dividing TR by the quantity sold, Q.
AR is equivalent to the price of the product,
where P x Q/Q = P, hence AR is also price.
 Marginal revenue

• Marginal revenue (MR) is the revenue

generated from selling one extra unit of a
good or service. It can be found by finding the
change in TR following an increase in output
of one unit. MR can be both positive and
negative.
 Revenue Schedule
Revenue schedule
P(£) (000) Qd A revenue TR (000)
schedule MR (000)
shows the amount of revenue generated by a firm

10 1 10  
9 2 18 8
8 3 24 6
7 4 28 4
6 5 30 2
5 6 30 0
4 7 28 -2
3 8 24 -4
2 9 18 -6
1 10 10 -8
 Revenue curves

• Total revenue
• Initially, as output increases total revenue (TR)
also increases, but at a decreasing rate. It
eventually reaches a maximum and then
decreases with further output.
 Average revenue

• However, as output increases the average

revenue (AR) curve slopes downwards. The AR
curve is also the firm’s demand curve.
 Marginal revenue

• The marginal revenue (MR) curve also slopes

downwards, but at twice the rate of AR. This
means that when MR is 0, TR will be at its
maximum. Increases in output beyond the
point where MR = 0 will lead to a negative
MR.