UNIT-2

PRODUCTION ANALYSIS &

FIRM THEORY

Dr. Ch.Venkata Krishna Reddy

Assistant Professor
 CONTENTS
– Economic Theory of Firm
– Theories of firm Baumol’s Model and
Agency Theory
– Production Function
– Law of Variable Proportions & ISO-Quants &
ISO Costs
– Least Cost Factor Combination
– Returns to Scale
– Economies and Diseconomies of Scale
 Economic Theory of Firm
There are two views of the firm:
1. Neoclassical (traditional) theory:
Firm is a calculating entity, that makes decisions, buys inputs,
making output, and selling for profit for loss.
2. Property Rights Theory:
Firm is a collection of contracts between owners of resources,
who wish to combine some portion of their resources, for some
period, for some purpose.
Incentives of Managers:
In the fast-food industry, about 30% of stores are company
owned and run by a salaried manager. About 70% of the stores
are run as franchises by owner-operators who split profits with
the parent company.
1. Which kind of store would you think would tend to be more
profitable?
2. Why then does the parent choose to own some? Where
would they be located?
3. Would you expect employees to see a difference in the
managers?
 Forms of Business Organization
 Sole proprietorships
 Partnerships
 Corporations
Fewest in number
Account for more business transactions
than the other two types combined
 Limited Liability Company (LLC)
Benefit of single taxation and limited
liability

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 Forms of Business Organization
 Sole Proprietorship (one person)
Easy to set up
No double taxation
No liability insulation to deflect outside
claims (unlimited liability)
When owner dies, business ends
Difficult to transfer ownership
Hard to raise capital (money to invest)
 Partnerships (More than one person)
General partners fully liable
Features:
Agreement Membership
Profit sharing Principal and agent relatio

Lawful business Collective Management
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 Forms of Business Organization
Kinds of Partners:
1. Active Partners 4. Nominal partner
2. Dormant or sleeping partner 5. Partner in profits
3. Limited or Special partners
Rights of Partners:
1. Every partner has a right to take part in the management of the business.
2. He has a right to inspect the books of accounts or to copy them.
3. He has right to express his opinion in the business dealings.
4. Every partner is a joint owner of all the assets including goodwill of the
firm.
Duties of Partners:
1. Every partner has to attend diligently(having or showing care) to his
duties in the conduct of the business.
2. He has to work to the greatest common advantage of the firm.
3. He has to account for any profits including secret profits made by him.
4. He has to render true accounts.
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5. He has to observe utmost good faith in 01/02/2025
his dealings with other partners.
 Forms of Business Organization
 Corporations
Legal “person” separate from owners
Can owe property, sue, be sued, enter into
contracts
Limited Liability (owners only lose up to
investment, debt responsibility of corp.)
Continuity of existence (Stock transferable –
when owner dies, corporation does not die)
Separation of owner and manager
 Allows continual existence, however it creates
agency problem
Easier to get external financing (equity & debt)
Double taxation
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 Forms of Business Organization
 Corporations
 Issue stock to stockholders
 Issue bonds to bondholders
 Carry out business activities for the
purpose of making profits
Not-for-profit corporations carry out charitable,
educational, or other philanthropic purposes
and are beyond the scope of this chapter
 Distribute the profits to their owners
 Pay interest to bondholders
 Reinvests earnings to buy more assets

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 Forms of Business Organization
 Advantages of Corporations
1. Limited liability
 The corporation is responsible for its own debt
 The stockholder can only lose up to the amount of his
or her investment
2. Ease of raising capital
 A corporation can issue stock to raise capital
 A corporation can have over a million stockholders
 A corporation can issue bonds to raise capital
3. Ease of transferring ownership rights
 Ownership rights in a corporation are represented by
shares of stock
 Stock can readily be transferred from one person to
another without the permission of other stockholders
 With partnerships, other partners have to give
permission for changes in ownership
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 Forms of Business Organization
 Advantages of Corporations
4. Continuous existence
 The length of life of a corporation is stipulated in its
charter
 When the charter expires, it may be renewed
 The death, incapacity, or withdrawal of an owner
does not affect the life of the corporation
5. No mutual agency
 Stockholders who are not officers do not have the
power to bind the corporation to contracts
 Owners need not participate in management
 The corporation is free to employ the managerial
talent it believes can best accomplish its objectives

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 Forms of Business Organization
 Disadvantages of Corporations
1. Additional taxation
 “Double taxation”
 Taxation of corporate income at two separate
points
 First, the net income of the corporation is
taxed because the corporation is a separate
entity
 When the net income is distributed as
dividends to stockholders, it becomes part of
the personal income of the individual
stockholder and is taxed a second time
 The corporation must pay charter fees (fees
paid for the corporation's right to exist)
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 Forms of Business Organization
 Disadvantages of Corporations
2. Government regulation
 States often regulate
 The amount of net income that a
corporation may retain
 The extent to which it may buy back its
own stock
 The amount of real estate it may own
 Securities And Exchange Commission
(SEC) requires that corporations file
financial statements quarterly and
yearly
 Sarbanes-Oxley Act
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Forms of Business Organization
The Financial Implications of the different Forms of
Business Organization
 The corporate form is superior when it comes
to raising cash:
 Ease of transferring ownership
 Business does not end each time stock is sold
 Unlimited life
 When owners die, the business does not end
 Limited liability for business debts
 Owners can only loose up to the amount they have
invested
 For good ideas to be implemented which in
turn creates profits for owners, cash is
required. Thus the business form which can
raise cash more easily is more beneficial
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KINDS OF COMPANIES
Joint Stock Companies are divided into different types on the basis of following:
On the Basis of Incorporations:
1. Chartered Companies: These are the companies formed by the grant of a Royal
Character. Ex: British East India Company
2. Statutory Companies: These are the companies formed by the enactment of
special Act by Parliament or State Assembly. Ex: RBI, SBI, LIC.
3. Registered Companies: These are the companies formed and registered under the
Companies Act, 1956. by the enactment of special Act by Parliament or State
Assembly. Ex: Tata Motors, Reliance
On the Basis of Membership:
1. Private Limited Company: According to the Companies Act, 1956 a private
limited company means a company which by its Articles --
a) One which has a minimum or Rs. One lakh paid up share capital or more
b) One which by its Articles of Association
1. Restricts the right to transfer its shares if any,
2. Limits the number of its members to 50 which will not include,
a) Members who are employees of the company and
b) Members who are ex-employees of the company and were members while such
employment and who have continued to be members after ceasing to be
employee.
3. Prohibits any invitation to the public to subscribe for shares or debentures of the
company
4. Prohibits any invitation or acceptance of deposits from persons other than its members,
directors or their relatives.
Special Privileges of a Private Company:
1. Number of Members
2. Allotment before minimum subscription
3. Prospectus
4. Commencement of business
5. Number of directors (2)
6. Statutory Meetings
7. Index of Members
8. Loan to directors
9. Need not having Qualification shares
10. No restriction on the number of directors
11. Appointment of managing director
12. Quorum of directors meeting (2)
13. Retirement of directors by rotation
14. Remuneration of Managers and directors (no need to approach Central
Govt.)
2. Public Limited Company: According to the Companies Act, 1956 a
company is said to be a public company if:
a) It is not a private company
b) It has a minimum paid up capital of Rs. 5 lakhs and above
c) It is a private company which is a subsidiary of any public company
Difference between Public and Private Limited Company
Points of Difference Public Limited Company Private Limited Company

1. Minimum Number At least Seven persons must be there Two persons will be enough
to form a public limited company to form a private limited com.
2. Maximum Number There is no limit to the maximum Maximum number of
number of share holders shareholders is limited to
fifty.
3. Minimum Paid-up The paid-up capital a public limited The paid-up capital a public
capital company should not be less than 5 limited company should not
lakhs be less than 1lakhs

4. Commencement of It has to obtain the Certificate of It will be enough if it gets

Business Commencement of business in ‘Certificate of incorporation’
addition to the ‘Certificate of to commence the business
Incorporation’ in order to commence
the business.
5. Minimum It has to secure minimum capital There is no such restriction
subscription before allotting it shares. and it can allot shares.
6. Issue of Prospectus It can invite public to subscribe for its It cannot invite the public and
shares and issue prospectus for that. as such cannot issue
prospecuts.
Difference between Public and Private Limited Company
Points of Difference Public Limited Company Private Limited Company

7. Transfer of shares The shares can be transferred easily Transfer of shares is

restricted.
8. Statutory meeting It must hold a statutory meeting with It need not hold any statutory
in six months from the date of meeting
commencement of business. It
should file the statutory report with
the Registrar of Companies
9. Articles of A public limited company may or It may have its own Articles of
Association may not have Articles. It can adopt Association
Table-A of Schedule I of Companies
Act.
10. No. of Directors There should be atleast three At least two directors are
directors for its management. required.
11. Qualification A person should possess certain This condition does not apply
shares minimum number of shares to to the directors of a private
qualify himself as a director limited company
12. Retirement of Not less than two thirds of the There is no compulsory
directors directors must retire from the retirement
management by rotation.
Difference between Public and Private Limited Company
Points of Difference Public Limited Company Private Limited Company

14. Name of the A public limited company has to add A private limited company
company the word ‘Limited’ at the end of its has to add the word ‘Private
name. Limited’ at the end of its
name.

15. Annual Report It has to file its Annual Report with It is not necessary
the Register of the Companies
16. Issues of shares A public limited company can issue A private limited company
warrants share warrants can not issue share warrants
17. Directors There are certain restrictions on the There is no such restrictions.
remuneration payment of remuneration.
18. Meeting quorum The quorum required for a meeting The quorum in case of a
of a public company is 5 persons private company is 2 persons
19. Inspection of The annual reports are public They are not open for
annual accounts documents. Any person can inspect inspection by non-members.
them.
The Agency Problem and Control of
the Corporation
The Conflicts Of Interest That Can Arise Between
Managers And Owners
 Creative accounting so that it looks like
stock value goes up?
Enron:
 Former Enron CFO Andrew Fastow, the alleged mastermind
behind Enron's complex network of offshore partnerships
and questionable accounting practices*
World Com:
 Former CEO, Bernard Ebbers was convicted (2005) of fraud
and conspiracy in the largest (to date) accounting scandal in
U.S. history, as a result of WorldCom's false financial
reporting, and subsequent 11 billion dollar loss to investors*
 Andrew and Bernard were agents that were supposed
to be serving the stockholders
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 The Agency Problem and Control of
the Corporation
Agency Problem
 How do you get managers inside the firm (managers
have custody of assets that belong to owners) to act
in the best interest of the owners?
 We must incur agency costs to minimize problems
Agency Cost
 Direct
Pay managers based on stock value (aligns
managers’ and owners’ interests)
 Allow external auditor to examine the financial
statements
 Have internal controls over assets and accounting
 Have internal auditors report to BofD
 Sarbanes-Oxley Act
 Makes managers personally responsible for 27
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The Agency Problem and Control of
the Corporation
Agency Cost
 Indirect
A profitable project that is risky may benefit
owners, but may put the manager’s job at risk
 If manager does not take on project Cost to
owner
Managers may create ways to pay themselves
great deals of money (accounting or other)
 Cost to owner

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 Production Function
 In Economic terms, production is a process of
transforming tangible and intangible inputs into
goods or services. The tangible inputs include raw
materials, land, labour and capital, whereas
intangible inputs include ideas, information and
knowledge. These inputs are also known as factors of
production.
 In economics, there are four major factors of production,
namely, land capital, labor, and enterprise.
 The production process of an organization can be
successful if it decides the quantity or goods to be
produced and the amount of inputs to be employed to
produce those goods.
 Production function expresses the technical
relationship between the inputs and the output. It
enables an organization to achieve maximum output
with the given combination of factors
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 Production Function
 In the short-run, change in production function is
brought by changing only one factor of production,
while keeping the other factors constant.
 On the other hand, in the long run, production function
changes with changes in only two factors of
production, labor and capital, while other factors
remain unchanged.
 According to James Bates and J.R. Parkinson,
“Production can be defined as an organized
activity of transforming physical inputs
(resources) in outputs (finished products) which
will satisfy the products’ needs of the society”.

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 Production Possibility Curve
 An economy has fixed population, resources,
techniques of production, and raw materials.
 It necessary to decide upon the optimum utilization of
resources to produce various goods.
 Production possibility curve provides an overview of
the maximum output of a good that can be
produced in an economy by using available
resources with respect to quantities of other
goods produced.
 In other words, Production possibility curve can be
defined as a graph that represents different
combinations of quantities of two goods that can
be produced by an economy under the condition of
limited available resources.
 It is also known as production possibility frontier or
transformation curve.
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 Production Possibility Curve
 Suppose an organization produces two goods A and B,
Table-1 shows different combinations of A and B
produced by organization:
 In figure-1 the Production Possibilities A (thousands)
Table-1: Production Possibilities B (thousands)
production possibility
P 0 20
point’s g and h are
attainable Q 2 14
combinations, whereas R 4 10
c and e are S 5 5
unattainable T 6 0
combinations.
Production possibility
 schedule
The ratecanatalso be a product is
which
termed as production
transformed into another product by
transformation
sacrificing the amount of one product
schedule.
for the other is called marginal rate of
transformation. For Example, in case of
A and B, the amount of B that is
sacrificed to produce A is termed a
marginal rate of transformation. Due to
this transformation, the curve of
production possibility is concave in
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 Production Function
 A function represents a relationship between two variables.
Y = f(X)
 A production function is expressed with reference to a
particular period of time.
 It expresses a physical relation because both inputs and
outputs are expressed in physical terms.
 Production function describes a purely technological
relation because what can be produced from a given
amount of inputs depends upon the state of technology.
 According to Samuelson, “Production Function is the
technological relationship which explains the quantity of
production that can be produced by a certain group of
inputs. It is related with a given state of technological
change”.
 Watson “The relation between a firm’s physical production
(output) and the material factors of production (input) is
referred to as production function”.
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 Types Production Function
 The nature of production function, i.e., how output varies
with change in the quantity of inputs, depends upon the
time period allowed for the adjustment of inputs.
 On the basis production function is classified into two
types:
 Short run production function – Time when one input (say,
capital) remains constant and an addition to output can be
obtained only by using more labor.
 Long run production function – Both inputs become
variable.

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 Iso-cost line
 Iso-cost line shows various combinations of inputs that
a firm can purchase or hire at a given cost. By the use of
iso-costs and iso-quants, a firm can determine the optimal
input combination to maximize profit.
 Iso-cost line represents the price of factors along with the
amount of money an organization is willing to spend on
factors. It shows different combinations of factors that
can be purchased at a certain amount of money.
 It is a graphical representation of various combinations of
inputs say Labor(L) and Capital(K) which give an equal
level of output per unit of time. Output produced by
different combinations of L and K is say, Q, then Q=f(L,K).
 A higher isoquant refers to a larger output, while a
lower isoquant refers to a smaller output.
 Example: A producer wants to spend Rs. 300 on the factors
of production, namely X and Y. The price of X in the market
is Rs. 3 per unit and price of Y is Rs. 5 per unit. In such a
01/02/2025 45
 Iso-cost line
 If the producer spends the
whole amount of money to
purchase X, then he/she can
purchase 100 units of X, which
is represented by OL. On the
other hand, if the producer
purchases Y with the whole
amount, then he/she would be
able to get 60 units, which is
represented by OH. If points H
and L are joined on X and Y
axes respectively, a straight  With the help of
line is obtained, which is called isoquant and iso-cost
iso-cost line. All the lines, a producer can
combinations of X and Y that determine the point at
lie on this line, would have the which inputs yield
same amount of cost that is maximum profit by
Rs. 300. Similarly, other iso- incurring minimum
01/02/2025 46

Least Cost Combination Principle
A rational firm/producer seeks maximization of profit.
 For this, he tries to minimize its cost of production.
 The cost is minimum, when input combination is optimal.
 Optimal input combination indicates the maximum returns
to the factors employed.
 Thus, a rational firm would combine the various factors of
production its production function in such a way that with the
minimum input and maximum output is obtained at the
minimum cost.
 Such a combination
Producer’s is referred
equilibrium occurs when he to as maximum
earns the least profit
cost
combination.
with optimal combination of factors.
 A profit maximization producer faces two choices of optimal
combination of factors (inputs)
1.To minimize its cost for a given output.
2.To maximize its output for given cost.
Thus the least cost combination of factors refers to a firm
producing the largest volume of output from a given cost &
producing a given level of output with the minimum 01/02/2025
cost when 47
 Assumption of Least Cost Combination
1. There are two factors of production – labour &
capital.
2. All units of labour & capital are homogeneous.
3. The prices of units of labour & capital are given &
constant.
4. The cost outlay is given.
5. The firm aims at profit maximization
The Least Cost Combination may be stated thus-
6. There is perfect competition in the factor market.
Marginal Productivity
____________________ Marginal Product of
____________________
of Labour = Capital
Price of Labour Price of Capital
MP MP MPL= Marginal Productivity
____
= ____
L

PL CP
ofPlabour
L= Price of labour
C
MPC= Marginal Productivity
of PCapital
C= Price of Capital
01/02/2025 48
01/02/2025 49
Least Cost Combination Principle between two factors
Combina Labour Capital Total Cost
tion (PL=$2) (Pc=$3)
A 1 6 20
B 2 3 13
C 3 2 12
D 4 1 15

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Units of X 01/02/2025 51

Assumption of Least Cost Combination
The isoquant curve is tangent to an iso-cost line.
 The iso-cost line GH is tangent to the iso-quant 2000 at point
M.
 The firm employs the combination of OC of capital & OL of
labour to produce 2000 units of output at point M with the
given cost-outlay GH.
 At this point, the firm is minimizing its cost for producing
2000 units.
 Any other combination on the iso-quant 2000, such as R or T
is on the higher iso-cost line KP which shows higher cost of
production.
 The Iso-cost line EF shows lower cost but output 2000 cannot
Limitation of Least Cost Combinations:
be attained with it.
1. Factors may not be perfectly divisible – perfect substitutions
 Therefore,
may the firm will choose the minimum cost point is
not be possible.
which is the least cost factor combination for producing 2000
2. It will be very difficult to calculate the marginal product of
unit of output.
each factor.
 M is the optimal combination for the firm.
3. The producer has to decide not only the best proportion
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 Returns to Scale
 The law of returns to scale explains the proportional
change in output with respect to proportional change
in inputs.
 The law of returns to scale states when there is a
proportionate change in the amounts of inputs, the
behavior of output also changes.
 The degree of change in output varies with change in the
Classification of Returns to Scale:
amount of inputs. Example: an output may change by a large
1. proportion,
Increasing returns
same proportion or small
2. Constant proportion
returns with respect
3. Diminishing returns
1. Increasing Returns to Scale:
to to
scale
change in input. to scale to scale
 If the proportional change in the output of an organization is
greater than the proportional change in inputs, the
production is said to reflect increasing returns to scale.
Example: to produce a particular product, if the quantity of
inputs is doubled and the increase in output is more
than double, it is said to be an increasing returns to scale.
 When there is an increase in the scale of production, the
average cost per unit produced is lower. This 01/02/2025
is because53
 A movement from a to b indicates that the amount of input is
doubled. Now, the combination of inputs has reached to
2K+2L from 1K+1L. However the output has increased from
10 to 25 (150% increase), which is more than double.
Similarly when input change from 2K+2L to 3K+3L, then
output changes from 25 to 50 (100% increase), which is
greater than change in input. This shows increasing returns
to scale. 01/02/2025 54
 Factors for Increasing Returns to Scale:
 Technical and managerial indivisibility: Implies that
there are certain inputs, such as machines and human
resources, used for the production process are
available in a fixed amount. These inputs cannot be
divided to suit different level of production.
 Example: an organization cannot use the half of the
turbine for small scale of production. Similarly, the
organization cannot use half of a manager to achieve
small scale of production. Due to this technical and
managerial indivisibility, an organization needs to employ the
minimum quantity of machines and managers even in case
 Specialization:
the level of production is muchthat
Implies less than
hightheirdegree
capacity of
producing output. of
specialization Therefore
man and whenmachinery
there is increase
helps inin
inputs, therethe
increasing is exponential increase in the
scale of production. The level
use ofof
output.
specialized labor and machinery helps in increasing the
 productivity
Concept of of labor and capital
Dimensions: Refers per unit.
to the Thisofresults
relation in
increasing
increasing returns
returns to scale to concept
to the scale. of dimensions. According to the
concept of dimensions, if the length and breadth 01/02/2025
of a room 55
 2. Constant Returns to Scale:
 The production is said to generate constant returns to
scale when the proportionate change in input is equal to
the proportionate change in output. For example, when
inputs are doubled, so output should also be
doubled,
 When therethen
is a itmovement
is a case of constant returns to scale.
from a to b, it indicates
that input is doubled. Now,
when the combination of
inputs has reached to
2K+2L from 1K+1L, then
the output has increased
from 10 to 20. Similarly,
when input changes from
 In constant returns to
2K+2L to 3K+3L, then
output changes from 20 to scale, inputs are divisible
30, which is equal to the and production function in
change in input. This homogeneous. 01/02/2025 56
 3. Diminishing Returns to Scale:
 Diminishing returns to scale refers to a situation when
the proportionate change in output is less than the
proportionate change in input. Example when capital
and labour is doubled but the output generated is
less than doubled, the returns to scale would be
termedthe
 When as diminishing
combinationreturns
of to scale.
labor and capital moves from
point a to point b, it indicates
that input is doubled. At point
a, the combination of input is
1K+1L and at point b, the
combination becomes
2K+2L. However the output
has increased from 10 to 18,  Diminishing returns to
which is less than change in
scale is due to dis-
the amount of input.
Similarly, when input
economics of scale,
changes from 2K+2L to which arises because 01/02/2025
of
57
END