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• UNIT- III

• Production, Cost, Market Structures & Pricing:


• Production Analysis: Factors of Production,
Production Function, Production Function with
one variable input, two variable inputs, Returns
to Scale, Different Types of Production Functions.
• Cost analysis: Types of Costs, Short run and Long
run Cost Functions.
• Market Structures: Nature of Competition,
Features of Perfect competition, Monopoly,
Oligopoly, and Monopolistic Competition.
• Pricing: Types of Pricing, Product Life Cycle based
Pricing, Break Even Analysis, and Cost Volume
Profit Analysis.
– Meaning of Production
• Production is the conversion of input into output.
– Factors of Production
• production is a process of transformation of factors of
production (input) into goods and services (output).
The factors of production may be defined as resources
which help the firms to produce goods or services. In
other words, the resources required to produce a
given product are called factors of production.
Production is done by combining the various factors of
production. Land, labour, capital and organisation (or
entrepreneurship) are the factors of production
(according to Marshall).
• We can use the word CELL to help us remember the
four factors of production: C. capital; Entrepreneurship;
L land: and L labour.
• Production Function
• Definition: The Production Function shows the relationship
between the quantity of output and the different quantities
of inputs used in the production process. In other words, it
means, the total output produced from the chosen quantity
of various inputs.
• The equation is expressed as follows:
• Q= f (L, K, T……………n)
• Where, Q = output
• L = labour K = capital
• T = level of technology
• n = other inputs employed in production.
• Assumptions of Production Function
• Technology.
• maximum level of efficiency.
• time.
• A change in any of the variable factors produces a
corresponding change in the output.
• Managerial Use of Production Function
• It helps to determine least cost factor
combination
• It helps to determine optimum level of output
• It enables to plan the production
• It helps in decision-making
• Variable Proportion Production Function
• Definition: The Variable Proportion
Production Function implies that the ratio in
which the factors of production such as labor
and capital are used is not fixed, and it is
variable. Also, the different combinations of
factors can be used to produce the given
quantity, thus, one factor can be substituted
for the other.
• Cobb-Douglas Production Function
• Definition: The Cobb-Douglas Production Function, given by Charles W.
Cobb and Paul H. Douglas is a linear homogeneous production function,
which implies, that the factors of production can be substituted for one
another up to a certain extent only.

• With the proportionate increase in the input factors, the output also
increases in the same proportion. Thus, there are constant returns to a
scale. In Cobb-Douglas production function, only two input factors,
labor, and capital are taken into the consideration

• Q = ALαKβ

• Where, Q = output
A = positive constant
K = capital employed
L = Labor employed
α and β = positive fractions shows the elasticity coefficients of outputs
for inputs labor and capital, respectively.
• Linear Homogeneous Production Function
• Definition: The Linear Homogeneous Production
Function implies that with the proportionate change in
all the factors of production, the output also increases
in the same proportion. Such as, if the input factors are
doubled the output also gets doubled. This is also
known as constant returns to a scale.
• nP = f(nK, nL)
• Where, n = number of times
nP = number of times the output is increased
nK= number of times the capital is increased
nL = number of times the labor is increased
• Thus, with the increase in labor and capital by “n”
times the output also increases in the same
proportion.
• Constant Elasticity of Substitution Production
Function
• Definition: The Constant Elasticity of Substitution
Production Function or CES implies, that any change in
the input factors, results in the constant change in the
output. In CES, the elasticity of substitution is constant
and may not necessarily be equal to one or unity.
• Fixed Proportion Production Function
• Definition: The Fixed Proportion Production
Function, also known as a Leontief Production
Function implies that fixed factors of production such
as land, labor, raw materials are used to produce a
fixed quantity of an output and these production
factors cannot be substituted for the other factors.
• Law of Returns of Scale:
• Law of Diminishing Returns or Law of Variable Proportion
• The law of variable proportion is also known as the
law of proportionality, the law of diminishing returns,
law of non-proportional outputs etc.
• As the proportion of one factor in a combination of
factors is increased, after a point, first the marginal and
then the average product of that factor will diminish”.
(F. Benham)
• The law of variable proportions refers to the behaviour
of output as the quantity of one Factor is increased
Keeping the quantity of other factors fixed and further
it states that the marginal product and average product
will eventually do cline. This law states three types of
productivity an input factor – Total, average and
marginal physical productivity.
• Assumptions of the Law: The law is based
upon the following assumptions:
• The state of technology remains constant. If
there is any improvement in technology, the
average and marginal out put will not
decrease but increase.
• Only one factor of input is made variable and
other factors are kept constant. This law does
not apply to those cases where the factors
must be used in rigidly fixed proportions.
• All units of the variable factors are
homogenous.
• Total Product or Total Physical Product (TPP):
This is the quantity of output a firm obtains in
total from a given quantity of input.
• Average Product or Average Physical Product
(APP): This is the total physical product (TPP)
divided by the quantity of input.
• Marginal Product or Marginal Physical Product
(MPP): It is the increase in total output that
results from a one unit increase in the input,
keeping all other inputs constant.
Variable factor Total product Average Marginal Stage
(Labour) Product Product

100 100 -
1

220 120 120


Stage I
2

270 90 50
3

300 75 30
4

320 64 20
Stage II
5

330 55 10
6

330 47 0
7

320 40 -10
Stage III
8
• In the first stage, total product increases at an increasing rate. The
marginal product in this stage increases at an increasing rate resulting in
a greater increase in total product. The average product also increases.
This stage continues up to the point where average product is equal to
marginal product. The law of increasing returns is in operation at this
stage. The law of diminishing returns starts operating from the second
stage awards.
• At the second stage total product increases only at a diminishing rate.
The average product also declines. The second stage comes to an end
where total product becomes maximum and marginal product becomes
zero.
• The marginal product becomes negative in the third stage. So the total
product also declines. The average product continues to decline.
• We can sum up the above relationship thus when ‘A.P.’ is rising, “M. P.’
rises more than “ A. P; When ‘A. P.” is maximum and constant, ‘M. P.’
becomes equal to ‘A. P.’ when ‘A. P.’ starts falling, ‘M. P.’ falls faster
than ‘ A. P.’. Thus, the total product, marginal product and average
product pass through three phases, viz., increasing diminishing and
negative returns stage. The law of variable proportion is nothing but
the combination of the law of increasing and demising returns.
• LAWS OF RETURNS TO SCALE
• The term return to scale means the changes in output as all factors change in the
same proportion. The law of returns to scale seeks to analyse the effects of scale
on the level of output. If the firm increases the units of both factors labour and
capital, its scale of production increases.The return to scale may be increasing,
constant or diminishing. We shall now examine these three kinds of returns to
scale.
• Increasing Returns to Scale
• When inputs are increased in a given proportion and output increases in a greater
proportion, the returns to scale are said to be increasing. In other words,
proportionate increase in all factors of production results in a more than
proportionate increase in output It is a case of increasing returns to scale.
• Constant Return to Scale
• When inputs are increased in a given proportion and output increases in the same
proportion, constant return to scale is said to prevail. For example, if inputs are
increased by 40% and output also increases by 40%, the return to scale are said to
be constant ( = 1). This may be called homogeneous production function of the
first degree.In case of constant returns to scale the average output remains
constant. Constant returns to scale operate when the economies of the large scale
production balance with the diseconomies.
• Decreasing Returns to Sale
• Decreasing returns to scale is otherwise known as the law of diminishing returns.
• This is an important law of production.If the firm continues to expand beyond the
stage of constant returns, the stage of diminishing returns to scale will start
operate. A proportionate increase in all inputs results in less than proportionate
increase in output, the returns to scale is said to be decreasing. For example, if
inputs are increased by 40%, but output increases by only 30%, ( = < 1),
• Production Function with Two Variable Inputs
• Let us now consider the case when the firm is expanding
production by using more of two inputs (varying) that are
substitutes for each other. A production function with two
variable inputs can be represented by isoquants. Isoquant
is a combination of two terms, namely, iso and quant.
• Iso means equal. Quant means quantity. Thus isoquant
means equal quantity or equal product. Isoquants are the
curves which represent the different combination of inputs
producing a particular quantity of output. Any point on the
isoquant represents or yields the same level of output.
• Thus isoquant shows all possible combinations of the two
inputs (say labour and capital) capable of producing equal
or a given level of output. Isoquants are also known as iso
product curves or equal product curves or production
indifferent curves.
• As more and more units of capital are
substituted to labour, each additional unit of
capital contributes less and less output, while
when labour is reduced each last unit of
labour contributes more and more to output,
because inefficient units of capital are coming
to production while inefficient units of labour
are going out of production. Marginal
productivity of capital will decrease and
marginal productivity of labour will increase