Chapter 5 - Production function (Part -2) - Chapter Notes, Micro Economics, Class 12 - Commerce PDF Download

RETRUN TO SCALE :: Return to scale describe the behaviour of total output as all inputs are changed by the same proportion .
In other words it tells changes in output when there is no change in factor ratio.
It is a LONG RUN CONCEPT :: In the long run all factors of production are variable
(1) INCREASING RETURNS TO SCALE :: Increasing returns to scale occurs when a given percentage increase in all factor inputs ( in some constant ratio ) causes proportionately greater increase in output.

100 % Increase in all factor inputs causes 120 % Increase in output.
The main cause of its operation is that internal and external economies of scale
(2) CONSTANT RETURNS TO SCALE :: Constant Returns to scale occurs when a given percentage increase in all factor input ( in some constant ratio ) causes equal percentage increase in output.
In mathematical terminology it is also called Linear and ' Homogenous Production Function

100 % Increase in all factor inputs causes 100 % Increase in output.
The main cause of its operation is that economies of scale gets couterbalanced by
diseconomies of scale

(3) DIMINISHING RETURNS TO SCALE :: Diminishing returns to scale occurs when a given percentage increase in all factor inputs ( in some constant ratio ) causes proportionately lesser increase in output .

100 % Increase in all factor inputs causes 80 % Increase in output.
The main cause of its operation is that diseconomies is more than economies of scale

ECONOMIES OF SCALE or
CAUSES OF INCREASING RETURN TO SCALE

Economies of scale refer to the situation in which increasing the scale of production reduce the
(a) per unit cost of production ; or
(b) raises output per unit of the factor inputs .
PROF. KOUSTSOYIANNIS “ Returns to scale are only one part of the economies of scale.Returns to scale are technical while economies of scale include the technical as well as monetary economies " Broadly, economies of scale are classified as:
(a) Internal economies of Scale
(b) External Economies of Scale

INTERNAL ECONOMIES OF SCALE
MEANING :: These are those economies that are available to a particular firm in the
industry which seeks to increase its level of output by way of increasing its scale of
production.
These are firm specific because these are not shared by other firm in the industry
(1) TECHNICAL ECONOMIES :: The technical economies arise mainly from indivisibilities of capital . Indivisibility means that machinery is availiable only in mimimum sizes or in different ranges of sizes. Effective utilisation of this quipment demands a high volume of production .Examples are
Economies of Increased Dimension : For example building of a double decker
bus, does not involve double the cost of labour and raw materials.It is less than double.
Economies of the Use of By-Product : sugar mills make power alcohol out of the molasses. Paper mill make paper out of cotton-waste.

(2) MANAGERIAL ECONOMIES :: A firm producing on large scale engage efficient and talented managers. The tasks of management is decentralized into different departments. Each department is headed by an expert who looks after each and every details of
his department .
(3) LABOUR ECONOMIES :: It becomes possible for the firm to introduce Division of Labour . It means allocation of work according to specialisation which results in greater efficiency and productivity.
Adam Smith illustrated this point with an example. A labourer, all alone can make
just 20 pins in a day. But when he divides the work of pin-making into different parts and each
part is given to a different labour then 2400 pins are made in a day.
(4) INVENTORY ECONOMIES :: A big firm possesse large stocks of raw materials . Such a firm also keeps in its stock large quantity of spare parts and small tools . When any of these things are in short supply and sold at high price, the firm has not to worry at all. Thus there is no fear of stoppage of production.
(5) SELLING or MARKETING ECONOMIES :: A firm propducing on large scale also enjoys several marketing economies in respect of sale of this large output. Examples (a) economies on account of advertisement
(b) firm can appoint its own sole distribution and authorized dealers
(c) A large firm can conduct its own research to effect improvement in the quality of the
product and reduce the cost of production.This enables the firm to produce quality products.
(6) FINANCIAL ECONOMIES :: A large firm has high credit rating. Thus it is in a
position to secure huge loan at low rate of interest.
(7) ECONOMIES OF RISK:: The capacity of the firm to bear greater risks is also
enlarged. It enables the firm to undertake such activities that assure high profit.
 

EXTERNAL ECONOMIES OF SCALE

MEANING :: It refer to all those benefits and facilities which are available to all the firm
of a given industry when the scale of operation of the industry as a whole expands.
These are industry specific. These are available to all the firm in the industry

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EXAMPLE :: Supposing there is only one motor car in a town , no one will set up a petrol pump
in such a town.
If the number of cars increases, a petrol pump will be set up .
If the number of cars increases still further then there will come into being service
stations, auto spare part sellers repair workshop etc.
Availability of these facitilites will prove beneficial and convenient to all the car owners

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(1) ECONOMIES OF CONCENTRATION :: When several firms of an industry establish
themselves at one place, then they enjoy many benefits together which help the firms to
develop and progress like
(a) Cheaper raw materials and capital equipment
(b) Development of skilled and trained labour
(c) Growth of ancillary // supportive industries (raw material industries, Banking,
insurance transportation)
(d) availability of development means of communications and transport
We find heavy concentration of jute industry in Bengal, tea industry in Assam, cotton textiles
at Ahmedabad, sports goods at Delhi and woodwork at Saharanpur.

(2) ECONOMIES OF INFORMATION :: When the number of firms in an industry increases, then it becomes possible for them to have concerted efforts and collective activities. They don’t feel the necessity of independent research on individual basis.
Scientific and trade journals are published. These journals provide sundry information such as new markets relating to the goods produced by the firms or the development of new production techniques abroad etc.
(3) ECONOMIES OF DISINTEGRATION :: When an industry develops, the firms engaged in it mutually agree to divide the production process among themselves. Every firm specializes in the production of particulars item concering that industry.For example
in case of cycle industry localized at a particular place, some firms specialize in the
manufacture of free wheels,other specialize in cycle chains, still others in pedals rims, hubs etc.
in textile industry some firms are engaged in spinning, others in weaving , still
others in dyeing etc..,

DISECONOMIES OF SCALE or
CAUSES OF DECREASING RETURN TO SCALE

(A) INTERNAL DISECONOMIES :: These diseconomies arise when a given firm increase its scale of production beyond a point. These do not affect the entire industry
(1) UNWIELDY MANAGEMENT :: As a firm expands , difficulties of management go an multiplying.
In a big firm, it becomes difficult to co- ordinate the work of different sections. It becomes a tough problem to supervise the work spread all over. It adversely affects operational efficiency of the firm.
(2) TECHNICAL DIFFICULTIES :: Beyond the optimum point, technology becomes uneconomical causing diseconomies of scale. For example, a machine can produce 5,000 metres of cloth, if it tires to produce more than 5,000 metres, the technical diseconomies will emerge.
(B) EXTERNAL DISECONOMIES :: When an industry in given area expands beyond certain limit then firm operating in that industry suffer external diseconomies. These diseconomies are suffered by all the firms in an industry and ar thus are not confined to any particular firm.
Firms experience great difficulties in procuring raw materials. Because of
large demand for raw material , it becomes scarce and expensive.
Availability of skilled labour, power and finance becomes difficult and
expensive.
Higher marketing cost and high pollution control cost.
Adverse effect of industrial policy.
Prohibition of localisation :: The government may also prohibit or restrict
expansion of and industry at a particular place

RELATIONSHIP BETWEEN INTERNAL & EXTERNAL ECONOMIES

Broadly there is very little difference between these two types of economies.
What may be external economy for firm X may be internal economy for firmY
If we take whole economy as a single unit then all types of economies will be of
internal type.
EXAMPLE ::
Any expansion in production capacity of steel industry shall bring in economies in the
form of internal economies to steel producers.
But due to availability of cheaper steel , others firm that use steel as a raw material shall
find reductions in their cost of production. These reduction shall be in the form of external economies for steel users.

DIFFERENTIATE BETWEEN INCREASING RETURN TO FACTOR &
INCREASING RETURN TO SCALE

(Q1) Differentiate between return to factor and return to scale
(Q2) The production function of a firm is Q = 5 L 1/2 K1/2
(a) Suppose 9 labour hours and 9 machine hours are used , what is the maximum
possible output that can be produced
(b) Suppose the firm doubles both th amount of labour and machine hours , calculate the
increase in output
(c) Comment on the nature of return to scale in the operation
(Q3) Distinguish between return to factor and return to scale ? Explain the reasons for increasing
return to factor and increasing return to scale ?

(Q4) All the input , used in the production of a good are increased in the same proportion. What
are its possible effects on total physical product ? Explain using numerical example.
or
Explain the effects on output when all are variable inputs and increased in same proportion ?
(Q5) Explain the concept of Return to Scale with the help of a single production function ?
(Q6) When does a production function satisfy increasing return to scale ? Mention two factors
behind increasing return to scale in the log run ?

(Q7) Find the law in the following table