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Unit-3
supply
 The supply of a commodity is the amount of the
commodity which the sellers or producers are
able and willing to offer for sale at a particular
price, during a certain period of time.
 According to J.L. Hanson- “By supply is meant
that amount that will come into the market
over a range of prices.”
Determinants of supply
1.
2.
3.
4.
5.
6.
7.
8.
Price of the commodity
Seller’s Expectations about the future prices
Nature of Goods
Natural Conditions
Transport conditions
Cost of Production
The State of Technology
Government’s Policy
Law of supply
 The Law of Supply states that- “Other things
remaining unchanged, the supply of a
commodity rises i.e., expands with a rise in its
price and falls i.e., contracts with a fall in its
price.”
Price
(in Rs.)
Quantity supplied
(in ‘000 per week)
10
10
20
13
30
20
40
25
40
30
20
10
0
10
15 20
25 30
Types of supply
 Market Supply- It is also called very short
period supply. Another name is day-to-day
supply. Eg- fish, vegetables, milk etc.
In this supply is not made according to the
demand of purchasers but as per availability of
the goods.
 Short-term supply- In short period supply, the
demand cannot be met as per requirements of
the purchaser. The demand is met as according
to goods available.
 Long-term Supply- In this, if demand has been
changed the supply can also be changed
because there is sufficient time to meet the
demand by making manufacturing goods and
supplying them in the market.
 Joint Supply- It refers to the goods produced or
supplied jointly e.g. cotton and seed; mutton
and wool. In joint supplied products one is
main product and the other is the by-product of
its subsidiary.
 Composite Supply- In this, supply of a
commodity is made from various sources and is
called the composite supply. We normally get
light from electricity, gas, kerosene and candles.
Thus, the way of supplying the light is called
composite supply.
Assumptions underlying the law of
supply
1.
2.
3.
4.
5.
6.
7.
8.
No change in the income
No change in technique of production
There should be no change in transport cost
Cost of production be unchanged
There should be fixed scale of production
There should not be any speculation
The prices of other goods should remain constant.
There should not be any change in the government
policies.
Exceptions to the Law of
supply
 In some exceptional cases where supply may
tend to fall with the rise in price and tend to
rise with the fall in price. Such exceptional
cases may beExceptions about future prices.
2. Supply of Labour
3. Rate of Interest and Savings position.
1.
Elasticity of supply
 Elasticity of Supply =
Percentage change in supply
Percentage change in Price
When elasticity of supply is equal to unity
Percentage change in price is equal to
percentage change in supply.
Eg- If price rises by 25% then supply also rises by
25%.
1.
2. When elasticity of supply is more than unity
Percentage change in supply is more than
percentage change in price.
Eg- If price rises by 50% then supply also rises by
75%.
3. When elasticity of supply is less than unity
Percentage change in price is more than
percentage change in supply.
Eg- If price rises by 50% then supply also rises by
25%.
What is production?

“Production is the process that transforms
inputs into output.”

“Production is the process by which the
resources (input) are transformed into a
different and more useful commodity.
Various inputs are combined in different
quantities to produce various levels of
output.”
Production
Management
Inputs
Labour,
Capital, Land,
Manpower,
Equipments
Transformation
Process
Control
Goods & Services
Pollution
Output
Production Function

Production function is defined as “the functional
relationship between physical inputs ( i.e., factors of
production ) and physical outputs, i.e., the quantity of
goods produced”.

Production function may be expressed as under:
Q = f ( K,L)
Where ;
Q = Output of commodity per
unit of time.
K = Capital.
L = Labour.
f = Functional Relationship.

Production function depends on :
○ Quantities of recourses used.
○ State of technical knowledge.
○ Possible process.
○ Size of firms.
○ Relative prices of factors of production.
○ Combination of factors.

Production decisions of a firm are
similar to consumer decisions
 Can also be broken down into three steps
 Production Technology
 Cost Constraints
 Input Choices
Production Decisions of a Firm
1.
Production Technology
 Describe how inputs can be transformed into
outputs
○
Inputs: land, labor, capital and raw materials
○ Outputs: cars, desks, books, etc.
 Firms can produce different amounts of outputs
using different combinations of inputs
Production Decisions of a Firm
2.
Cost Constraints
 Firms must consider prices of labor, capital and
other inputs
 Firms want to minimize total production costs
partly determined by input prices
 As consumers must consider budget constraints,
firms must be concerned about costs of
production
Production Decisions of a Firm
3.
Input Choices

Given input prices and production technology,
the firm must choose how much of each input to
use in producing output
 Given prices of different inputs, the firm may
choose different combinations of inputs to
minimize costs
○
If labor is cheap, firm may choose to produce with
more labor and less capital
Relationship between tp, ap & mp
Qty of Labour
TP
AP
MP
1
100
100
100
2
210
105
110
3
330
110
120
4
430
107.5
100
5
520
104
90
6
600
100
80
7
670
95.7
70
8
720
90
50
9
750
83.3
30
10
760
76
10
11
740
67.2
-20
Laws of Production
Short Run
One variable input
(Law of Variable)
Two variable inputs
(Isoquant analysis)
Long Run
All inputs variable
(Returns to Scale)
Short Run Production Function: The Law of
Variable Proportions
 Statement of the law:
“The law of variable proportions states that when more and more
units of the variable factor are added to a given quantity of
fixed factors, the total product may initially increase at an
increasing rate reach the maximum and then decline”.
 This is the new name given to Law of Diminishing
Returns.
Assumptions
1. The law applies only in the short run.
2. One factor of production is variable &
others are fixed.
3. All units of variable factor are
homogeneous.
4. State of technology is given & remains the
same.
5. Factor proportions can he changed.
 Key terms in production analysis
 Total product (TP): The total amount of output
resulting from a given production function
 Average product(AP): Total product per unit of given
input factor.
 Marginal product(MP): The change in total product
per unit change in given input factor.
Three Stages of Production in
Short Run
(i) Stage of Increasing Returns. The first stage of the law of
variable proportions is generally called the stage of
increasing returns. In this stage as a variable resource
(labor) is added to fixed inputs of other resources, the
total product increases up to a point at an increasing rate
as is shown in figure 11.1.
The total product from the origin to the point F on the slope of
the total product curve increases at an increasing rate. From
point F onward, during the stage II, the total product no
doubt goes on rising but its slope is declining. This means
that from point F onward, the total product increases at a
diminishing rate. In the first stage, marginal product curve
of a variable factor rises in a part and then falls. The average
product curve rises throughout .and remains below the MP
curve.
1.
Increasing return to a factor:-
(i) Fuller utilization of fixed factor : In the initial
stages Fixed factor remain under utilized its fuller
utilization starts with the more application of
variable factor, hence, initially additional unit of
variable factors add more to the total output
(ii) Specialization of Labour :- Additional
application of Variable factor causes process
based division of Labour that raises the efficiency
of factors. Accordingly marginal productivity
tends to rise.
(ii) Stage of Diminishing Returns. This is the most
important stage in the production function. In stage
2, the total production continues to increase at a
diminishing rate until it reaches its maximum point
(H) where the 2nd stage ends. In this stage both the
marginal product (MP) and average product of the
variable factor are diminishing but are positive.
(iii) Stage of Negative Returns. In the 3rd stage,
the total production declines. The TP, curve
slopes downward (From point H onward). The
MP curve falls to zero at point M and then is
negative. It goes below the X axis.
2. Diminishing return to a factor:(i) Imperfect factor substitutability :- Factors of
production are imperfect substitutes of each other.
More & more of Labour, for eg. Cannot be
continuously used in place of additional capital.
Accordingly diminishing returns to variable factor
becomes inevitable.
(ii) Disturbing the optimum proportion :Continuous increase in application of variable
factor along with fixed factors beyond a point
crosses the limit of ideal factor ratio. This results in
poor co-ordination between the fixed & variable
factors which causes diminishing return to a factor.
3. Negative returns to a factor :(i)Overcrowding :- When more & more variable
factors are added to a given quantity of fixed
factor it will lead to over crowding & due to this MP
of the Labours decreases & it goes into negative
(ii) Management Problems :- When there are too
many workers they may shift the responsibility to
others & it becomes difficult for the management to
coordinate with them. The Labours avoid doing
work. All these things lead to decrease in efficiency
of Laboures. Thus the output also decreases.
 Importance:
(i) It is helpful in understanding clearly the
process of production. It explains the input
output relations. We can find out by-how much
the total product will increase as a result of an
increase in the inputs.
(ii) The law tells us that the tendency of
diminishing returns is found in all sectors of
the economy which may be agriculture or
industry.
(iii) The law tells us that any increase in the units
of variable factor will lead to increase in the
total product at a diminishing rate.
Production Function in Long Run
 Laws of Returns to Scale (All variable
inputs)
The percentage increase in output when all inputs vary in
the same proportion is known as returns to scale. It
obviously relates to greater use of inputs maintaining the
same technique of production.
 Three Situations of Returns To Scale
- Increasing Returns to Scale
- Constant Returns to Scale
- Decreasing Returns to Scale
Table showing Returns to Scale
Factor
Combinations (in
Quintals)
Total Product (in
Quintals)
Marginal Product
(in Qunitals)
1
2
2
6
2 Increasing
4 Returns
3
4
5
12
18
24
6 Constant
6 Returns
6
6
7
28
30
4 Diminishing
2 Returns
Increasing
8
Decreasing
Constant
7
Stage II
MP (in Quintals)
6
5
4
3
2
1
0
1
2
3
4 5 6 7
8
Factors Combinations
 Increasing Returns to Scale- when the ratio
between factors of production is kept fixed and
the scale is expanded, initially output increases
in a greater proportion than the increase in the
factors of production.
 Constant Returns to Scale- Returns to scale
become constant as the increase in total output
is in exact proportion to increase in inputs. If
the scale of production is increased further,
total returns will increase in such a way that the
marginal returns become constant.
 Diminishing Returns to scale- After a limit
when the quantity of factors of production is
increased in such a way that the output
increases in a smaller proportion as compared
to increases in the amounts of the factors of
production.
Long run production function with
two variable inputs
 If both, capital and labour are variable, a different set
of analytical techniques is applied to determine the
optimal input rates.
Selection of optimal combinations will depend upon:
 Technical possibilities, of factor substitution (Isoquants)
 Prices of factors of Production (Isocost lines)
isoquants
An isoquant represents all those combinations of
inputs, which are capable of producing same
level of output. Isoquants are also called equalproduct or iso-product curves.
Various combinations of X and Y to produce a
given level of output, say 100 units.
Factor
Combination
Factor X
Factor Y
A
1
12
B
2
8
C
3
5
D
4
3
E
5
2
14
A
12
Factor Y
10
B
8
C
6
4
D
E
2
0
1
2
3
4 5
Factor X
Iso-cost or equal-cost lines
E
C
A
The X-axis shows the units of factor
X and Y axis the units of factor Y.
When entire amount Rs. 1000 are
spent on factor x we get OB and the
entire amount is spent on factor y
we get OA. The straight line AB
which joins points A and B will pass
through all combinations of Factor
X and Y which the fir can buy with
Rs. 1000.
The line AB is called iso-cost lines.
Factor y
Iso-cost lines represents the prices
of factors.
O
B D
Factor X
F
Least combinations of factors
by imposing iso-quant and isocost lines
Cost analysis
 It refers to the study of behavior of cost in
relation to one or more production criteria,
namely, size of output, scale of operations,
prices of factors of production and other
relevant economic variables.
 Cost Concepts- These are relevant for Business
operations and decisions. Important concepts
of costs are:
1. Private and Social Cost- Private cost refers to
the cost of production to an individual
producer.
Social cost refers to the cost of producing
commodity to society in the form of resources
that are used to produce it.
2. Opportunity cost and Actual CostOpportunity cost is the loss of earnings due to
lost opportunities. These are foregone due to
scarcity of resources. It is also called
Alternative cost.
Actual cost or Outlay cost or Absolute costs are
the actual amount of expenses incurred for
producing or acquiring a good or service.
3. Past costs and Future costs- Past costs or
Historical costs are records of past costs.
Future costs are based on forecasts.
4. Explicit cost and Implicit cost- Explicit costs
are those which are paid by employer to the
owners of the factor units which do not belong
to the employer itself.
Implicit costs arise when factor units are owned
by employer himself.
5. Incremental (Differential) costs and Sunk
costs- Incremental costs is the additional cost
due to change in the level or nature of business
activity. The change may take several forms- (i)
Addition of new product line, (ii) Changing
channel of distribution, (iii) Addition of a new
machine, (iv) Replacing a machine by a better
one etc.
Sunk cost is one which is not affected or
altered by a change in the level or nature of
Buss. Activity. Eg- Depriciation.
6. Short run and Long run costs- Short run costs
are costs that vary with output or sales when
fixed plant and capital equipment remain the
same.
Long run costs are those which vary with
output when all output factors including plant
and equipment vary.
7. Fixed and Variable costs- Fixed costs remain
constant regardless changes in volume of
production and sales upto a certain level of
output.
Variable costs vary in total in direct
proportion to changes in volume.
8. Direct and InDirect Costs- A Direct or
Traceable cost is one which can be identified
easily.
Indirect costs or common costs are not easily
traceable.
9. Shut-down and Abandonment Cost- Shutdown costs are these costs which would be
incurred in the event of suspension of the plant
operation.
Abandonment costs are the costs of retiring
altogether a plant from service.
10. Out of Pocket and Book Costs- Out of pocket
costs involves current cash payments to
outsiders.
Book costs such as depreciation, do not require
current cash payments.
11. Replacement Cost- It means the price that
would have to be paid currently to acquire the
same plant.
12. Economic Cost- The economic cost of a
decision depends on both the cost of the
alternative chosen and the benefit that the best
alternative would have provided if chosen.
13. Real Cost- The cost of producing a good or
service, including the cost of all resources used.
14. Money Cost- Money cost is basically the
interest rate a company will pay for loans.
15. Accounting Cost- The actual outlays or
expenses incurred in production that shows up
a firm's accounting statements or records.
Cost Function- It refers to the mathematical
relation between cost of a product and the
various determinants of costs.
C = f(O,S,P,…..)
Where, C is Cost
O is level of Output
S is Size of Plant
P is prices of factor of production
 Costs in Short Run
In short run cost-output relationship needs to
be discussed in terms of
1) Total cost
2) Average Cost
3) Marginal Cost
1) Short-Run Total Costs- The scale of
organization being fixed, the short-run total
costs are divided into total fixed and total
variable cost.
TC = TFC + TVC
TC
Cost 400
($ per
year)
VC
300
200
100
FC
50
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Output
2) Short-Run Average cost- It diminishes
continuously as output increases.
AFC = TFC
Q
3) Short-Run Average Variable cost- The average
variable costs first declines with the rise in
output but eventually they began to rise.
AVC = TVC
Q
4) Short-Run Average Total Cost = AFC + AVC
5) Short-Run Marginal Cost- It is the addition to
total cost by producing an additional unit of
output.
MC
AC
Costs (£)
AVC
AFC
Output (Q)
Long- Run Average Cost Curves
SRAC1 SRAC
2
SRAC5
SRAC3
SRAC4
Costs
LRAC
Output
In the short run the firm can be operating on any
short run average cost curve given the size of
plant.
But in Long run, the firm will examine with
which size of plant or on which short average
cost curve it should operate to produce a given
level of output so that total cost is minimum.
Costs per unit
LRATC
0
SRMC1
SRATC1
SRMC2
SRATC2 SRATC3
SRMC3
Q2
Q3
Quantity
Internal economies
Internal economies are economic advantages
which enable a firm to get proportionately large
output than increments in factor inputs.
 Technical economies are the cost savings a
firm makes as it grows larger, and arise from the
increased use of large scale mechanical
processes and machinery. For example, a mass
producer of motor vehicles can benefit from
technical economies because it can employ
mass production techniques and benefit from
specialisation and a division of labour.
 Purchasing economies are gained when larger
firms buy in bulk and achieve purchasing
discounts. For example, a large supermarket
chain can buy its fresh fruit in much greater
quantities than a small fruit and vegetable
supplier.
 Administrative savings can arise when large
firms spread their administrative and
management costs across all their plants,
departments, divisions, or subsidiaries. For
example, a large multi-national can employ one
set of financial accountants for all its separate
businesses.
 Large firms can gain financial
savings
because they can usually borrow money more
cheaply than small firms. This is because they
usually have more valuable assets which can be
used as security, and are seen to be a lower risk,
especially in comparison with new businesses.
In fact, many new businesses fail within their
first few years because of cash-flow
inadequacies. For example, for having a bank
overdraft facility, a supermarket may be charged
2 or 3 % less than a small independent retailer.
 Risk bearing economies are often derived by
large firms who can bear business risks more
effectively than smaller firms. For example, a
large record company can more easily bear the
risk of a ‘flop’ than a smaller record label.
External economies
External economies are those economies in
production which depend on increase in the
output of the whole industry rather than on
increase in the output of the individual firm.
 Availability
of cheaper transport and
communication facilities.
 Availability of skilled labour.
 Cheaper banking and financial services.
 Development of specialised marketing agencies
and facilities of joint publicity.
 Provision of
adequate power, water and
electricity.
 Interaction with other concerns in research and
development by pooling manpower and
financial resources and protecting the mutual
interests of all to improve the production
process and reduce cost of production.
 Easy availability of information regarding
sources of supply, emerging new markets, scope
of international markets, etc.
 Economy in disposal of wastes and effluents by
use of common facilities where several firms are
localized.
Internal diseconomies
Internal diseconomies are those factors which raise
the cost of production of a firm as its scale of
production is increased beyond a point.
 Larger firms often suffer poor communication
because they find it difficult to maintain an
effective flow of information between departments,
divisions or between head office and subsidiaries.
Time lags in the flow of information can also create
problems in terms of the speed of response to
changing market conditions. For example, a large
supermarket chain may be less responsive to
changing tastes and fashions than a much smaller,
‘local’ retailer.
 ‘X’ inefficiency is the loss of management
efficiency that occurs when firms become large
and operate in uncompetitive markets. Such
loses of efficiency include over paying for
resources, such as paying managers salaries
higher than needed to secure their services, and
excessive waste of resources. ‘X’ inefficiency
means that average costs are higher than would
be experienced by firms in more competitive
markets.
 Low motivation of workers in large firms is a
potential diseconomy of scale that results in
lower productivity, as measured by output per
worker.
 Co-ordination problems also affect large
firms with many departments and divisions,
and may find it much harder to co-ordinate its
operations than a smaller firm. For example, a
small manufacturer can more easily co-ordinate
the activities of its small number of staff than a
large manufacturer employing tens of
thousands.
External diseconomies
External diseconomies are external costs that
spill over into other firm’s costs such as:
 A firm in course of expanding its output may
cause so much pollution that it would increase
the cost of disposing waste materials for other
firms in the same area.
 Pollution of lakes and rivers creates external
diseconomy for the fishing industry and health
hazards for the people.
 Creation of new shopping complex increases
traffic causing external diseconomy to the
inhabitants of that area.
 Concentration of firms in an area might
increase the wage rates to all firms in that area.