Chapter 5

Firm as a Producer

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 Creation of a firm

• To minimize Transaction costs

• One entity takes the responsibility to bring all
the factors together required for production

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 PRODUCTION
• The term “Production” means
transformation of physical “Inputs” into
physical “Outputs”.
• Production always results in either creation of
new utilities or addition of values
• It is to be noted that higher levels of
production is an index of progress and growth
of an organization and that of a society.
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 Production Function
• “A production Function” expresses the
technological or engineering relationship
between physical quantity of inputs
employed and physical quantity of outputs
obtained by a firm over a period of time.
• Factor inputs are of two types
• Fixed Inputs: land, buildings, machines …
Variable inputs: raw materials, power…
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 Production Function
• 1. Short Run Production Function
• 1. Quantities of all inputs constant and only
one variable input will be varied. For
example, Law of Variable Proportions.
• 2. Quantities of all factor inputs are kept
constant and only two variable factor inputs
are varied. For example, Iso-Quants and
Iso-Cost curves.
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 Production Function
2. Long Run Production Function
• The producer will vary the quantities of all factor
inputs, both fixed as well as variable in the same
proportion. For Example, The laws of returns to
scale.
1. The quantity of inputs may be reduced while the quantity of output
may remain same.
• 2. The quantity of output may increase while the quantity of inputs
may remain same.
• 3. The quantity of output may increase and quantity of inputs may
decrease.
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“Law of Diminishing Returns”
• Assumptions of the Law
1. Only one variable factor unit is to be varied while all other factors
should be kept constant.
Different units of a variable factor are homogeneous.
Techniques of production remain constant.
The law will hold good only for a short and a given period.
There are possibilities for varying the proportion of factor inputs.
Illustration
• A hypothetical production schedule is worked out to explain the
operation of the law.

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“Law of Diminishing Returns”
• Fixed factors = 1 Acre of land + Rs 5000-00 capital.
Variable factor = labor.
• Total Product or Output:
• (TP) It is the output derived from all factors units, both
fixed & variable employed by the producer. It is also a
sum of marginal output.

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“Law of Diminishing Returns”

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“Law of Diminishing Returns”

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Motive behind existence of a Firm
• Profits
- economic Profits
- total revenue minus total ‘economic’ costs

• Economic costs are ‘relevant’ costs using the

principle of opportunity costs

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 Marginal Analysis

• Used to arrive at the profit-maximizing output

level
• Uses the concepts of Marginal revenue and
Marginal Cost
• Marginal revenue is the change in total
revenue due to an additional unit of output
• Marginal cost is the change in total cost due to
an additional unit of output

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 Production function with Two
Variable Inputs
• ISO-Quants and ISO-Costs
– The prime concern of a firm is to workout the
cheapest factor combinations to produce a
given quantity of output.
– Iso-product curve is a technique developed in
recent years to show the equilibrium of a
producer with two variable factor inputs.
– Parallel to …???
– INDIFFERENCE CURVE (FROM CONSUMPTION)

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 Production function with Two
Variable Inputs
• URVE (FROM CONSUMPTION)

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 Production function with Two
Variable Inputs
• URVE (FROM CONSUMPTION)

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 Production function with Two
Variable Inputs
• Iso – Quant Map
– Number of Iso Quants representing different
amount of out put are known as Iso-quant map.
• (FROM CONSUMPTION)

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 Production function with Two
Variable Inputs
• Marginal Rate of Technical Substitution (MRTS)
• It may be defined as the rate at which a factor of production can be
substituted for another at the margin without affecting any change in
the quantity of output.

• Law of Diminishing Marginal Rate of Technical

Substitution (DMRTS). ROM CONSUMPTION)

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 Production function with Two
Variable Inputs
• Properties of Iso- Quants:
1. An Iso-Quant curve slope downwards from left to
right.
2. Generally an Iso-Quant curve is convex to the
origin.
3. No two Iso-product curves intersect each other.
4. An Iso-product curve lying to the right represents
higher output and vice-versa.
5. Always one Iso-Quant curve need not be parallel to
other.
6. It will not touch either X or Y – axis.
• ROM CONSUMPTION)

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 Production function with Two
Variable Inputs
• ISO-Cost Line or Curve (FROM CONSUMPTION)

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 Production function with Two
Variable Inputs
• URVE (FROM CONSUMPTION)

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 Production function with Two
Variable Inputs
• URVPRODUCERS EQUILIBRIUM
(Optimum factor combination or least cost combination).
E (FROM CONSUMPTION)

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 Profit-maximizing Rules

• Rule- The level of output at which MR = MC

• Should this level of output be produced at all?
- Shut Down Rule:
If at the optimal level of output, Average
Revenue is less than Average (economic) Cost,
then, SHUT DOWN.

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 Long Run Production Function
• Long Run Production Function [Change
In All Factor Inputs In The Same
Proportion]
• Laws of Returns to Scale
• Three Phases of Returns to Scale
– Increasing Returns to Scale:
– Constant Returns to Scale
– Diminishing Returns to Scale
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 Long Run Production Function

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 Long Run Production Function

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 Long Run Production Function
• Increasing Returns to Scale:
– Increasing returns to scale is said to operate
when the producer is increasing the quantity of
all factors [scale] in a given proportion, output
increases more than proportionately. For
example, when the quantity of all inputs are
increased by 10%, and output increases by
15%

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 Increasing Returns to Scale

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 Long Run Production Function
• Causes for Increasing Returns to Scale
– Increasing returns to scale operate in a firm on account
of several reasons. Some of the most important ones
are as follows:
1. Wider scope for the use of latest tools, equipments, machineries,
techniques etc to increase production and reduce cost per unit.
2. Large-scale production leads to full and complete utilization of
indivisible factor inputs leading to further reduction in production
cost.
3. As the size of the plant increases, more output can be obtained at
lower cost.

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 Long Run Production Function
• Causes for Increasing Returns to Scale
4. As output increases, it is possible to introduce the principle of
division of labor and specialization, effective supervision and scientific
management of the firm etc would help in reducing cost of operations.
5. As output increases, it becomes possible to enjoy several other
kinds of economies of scale like overhead, financial, marketing and risk-
bearing economies etc, which is responsible for cost reduction.
It is important to note that economies of scale outweigh diseconomies
of scale in case of increasing returns to scale.

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 Long Run Production Function
• Constant Returns to Scale
– Constant returns to scale is operating when all
factor inputs [scale] are increased in a given
proportion, output also increases in the same
proportion. When the quantity of all inputs is
increased by 10%, and output also increases
exactly by 10%

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 Constant Returns to Scale

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 Long Run Production Function
• Constant Returns to Scale
– Causes for Constant Returns to Scale
• various internal and external economies of scale are
neutralized by internal and external diseconomies
• Thus, when both internal and external economies
and diseconomies are exactly balanced with each
other, constant returns to scale will operate.

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 Long Run Production Function
• Diminishing Returns to Scale
– Diminishing returns to scale is operating when
output increases less than proportionately when
compared the quantity of inputs used in the
production process. For example, when the
quantity of all inputs are increased by 10%,
and output increases by 5%

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 Diminishing Returns to Scale

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 Long Run Production Function
• Diminishing Returns to Scale
– Causes for Diminishing Returns to Scale
1. Emergence of difficulties in co-ordination and control.
2. Difficulty in effective and better supervision.
3. Delays in management decisions.
4. Inefficient and mis-management due to over growth
and expansion of the firm.
5. Productivity and efficiency declines unavoidably after a
point.

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 Do Firms really maximize Profits?

• Satisficing Theory
• Other Objectives:
- provide good products/services to
customers
- a good work place for employees
- responsibility to society

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 Control Mechanisms

• Principal – Agency Cost

Therefore CONTROL MECHANISMS

Internal External
-board of Directors - Takeovers
- ESOPs

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 Non- Profit Firms

• No right to accumulate Profits

• Operate with funds from external sources

• Exempt from Corporate Tax

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 Public Sector Firms

• Operate in areas where Private sector will not

operate

• Involved in the provision of Public goods

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 Global firms
• What characterizes MNCs?
- Operations in several countries
- production /trading activities all over the
world
- Substantial direct investment in foreign
countries and actively engaged in the
management

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 Global firms
• What is attractive about being an MNC?

- Access to multiple sources of supply and

markets- global access

- So rework costs towards higher profits

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 Global firms
• How to become a MNC?
- Through licensing

- Through exports

- Through Foreign Direct Investments

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 Global firms
• Complications:
- Coping with country specific features

- Differences in factor costs

- Differing contexts complicate competitive

strategies

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