BUSINESS ECONOMICS

UNIT-4
Production-Law of Variable Proportion-Economies of scale-Break even
analysis.
What is the Production Function?
Production Function is the relationship between physical inputs (land,
labour, capital, etc.) and physical outputs (quantity produced).
It is a technical relationship (not an economic relationship) that studies
material inputs on one hand and material outputs on the other hand.
Material inputs include variable and fixed factors of production.
In a standard equation, the Production function is represented by Q, Labour
(Variable element) is represented by L, and Capital (Fixed element) is
represented by K.

Assumptions of Production Function

● Both inputs and outputs are divisible.
● There are only two factors of production, i.e., land (Variable
element) and capital (Fixed element).
● Factors of production are imperfect substitutes.
● Technology is constant.

Graphical Representation of Production Function

For example, When there are 4 units of labour and 5 units of capital, the
equation for the production function is Q = f(4,5).
Variable Factors are the factors that can be changed during the course of
the short run. Variable factors vary with the level of output. An increase in
variable factors leads to more production and vice-versa. Variable factors
include labour, power, fuel, etc.

Fixed Factors are the factors that can not be changed in the short run. The
number of fixed factors always remains constant even when there is zero
production. Fixed factors include land, capital, building, etc.

What Are the Factors of Production?

The factors of production are an important economic concept outlining the
elements needed to produce a good or service for sale. They are
commonly broken down into four elements: land, labour, capital, and
entrepreneurship.

Features of Production Function

1. Complementary: A producer will have to combine the inputs to produce
outputs. Outputs can not get generated without the use of inputs.
2. Specificity: For any given output, the combination of inputs that may be
used is clearly defined. What type of factors are needed for the production
of a particular product is clearly mentioned before the actual production
gets started.
3. Production Period: The period of the production process is clearly
explained to the production unit. Each stage of production is given some
specific time. Production generally gets completed over a long period of
time.

Types of Production Function

Production function on the basis of the time period can be divided into two
categories: Short Run Production Function and Long Run Production
Function. In these production functions, the combination and behaviour of
variable factors and fixed factors are different.
1. Short Run Production Function: Short Run is a period of time where
output can only be changed by changing the level of variable inputs. In the
short run, some factors are variable and some are fixed. Fixed factors
remain constant in the short run like land, capital, plant, machinery, etc.
Production can be raised by only increasing the level of variable inputs like
labour. Therefore, the situation where the output is increased by only
increasing the variable factors of input and keeping the fixed factors
constant is termed as Short Run Production Function. This relationship
is explained by the ‘Law of Variable Proportions.’
2. Long Run Production Function: Long Run is a span of time where the
output can be increased by increasing all the factors of production whether
it is fixed (land, capital, plant, machinery, etc.) or variable (labour). Long run
is enough time to alter all the factors of production. All factors are said to be
variable in the long run. Therefore, the situation where the output is
increased by increasing all the inputs simultaneously and in the same
proportion is termed Long Run Production Function. This relationship is
explained by the ‘Law of Returns to Scale.’

Concept of Product
The concept of product can be looked at from three different angles: Total
Product, Marginal Product, and Average Product.
1. Total Product: Total Product (TP) refers to the total quantity of goods
that the firm produced during a given course of time with the given number
of inputs. Total Product is also known as Total Physical Product (TPP) or
Total Output or Total Return. For example, if 6 labourers produce 10 kg
of wheat, then the total product is 60 kg. A company can increase TP in the
short term by focusing primarily on the variable components. But over time,
both fixed and variable elements can be increased to raise TP.
2. Average Product: Average Product refers to output per unit of a
variable input. AP is calculated by dividing TP by units of the variable
factor. For example, if the total product is 60 kg of wheat produced by 6
labours (variable inputs), then the average product will be 60/6, i.e., 10 kg.
3. Marginal Product: Marginal Product refers to the addition to the total
product when one more unit of a variable factor is employed. It calculates
the extra output per additional unit of input while keeping all other inputs
constant. Other names of Marginal Product are Marginal Physical
Product (MPP) or Marginal Return.
MPn = TPn – TPn-1

Here,
MPn = Marginal product of nth unit of the variable factor,
TPn = Total product of n units of the variable factor, and
TPn-1 = Total product of (n-1) units of the variable factor

What is the Law of Variable Proportions?

The Law of Variable Proportions, also known as the Law of Diminishing
Returns, is a fundamental principle in economics that describes how the
output of a production process changes as the quantity of one input varies
while other inputs are kept constant. This law is applicable in the short run,
where at least one factor of production (such as capital) is fixed.

Assumptions of the Law of Variable Proportion

1. It operates in the short run because the factors are categorised as
variable and fixed.
2. The law is applicable to all fixed factors, including land.
3. The law of variable proportions allows for the combination of
several variable units with fixed factors.
4. This law primarily applies to the production sector.
 5. It is simple to calculate the impact of a change in output caused by
a change in variable factors.
6. It is considered that after a certain point, factors of production
become imperfect substitutes for one another.
7. In order for this law to function, it is assumed that the state of
technology would remain constant.
8. All variable factors are thought to be equally effective.

Example of Law of Variable Proportion

Let’s say a farmer has 1 acre of land (i.e., fixed factor) and wants to use
labour (i.e., variable factor) to improve the production of rice there. The
output increased initially at an increasing rate, then at a decreasing rate,
and finally at a negative rate as he employed more and more units of
labour. The below table displays the output behaviour in this case.

Fixed Variable
TP MP
Factor Factor Phase
(units) (units)
(Land) (Labour)

1 1 5 5

Phase I: Increasing
Returns to a Factor

1 2 20 15

1 3 32 12 Phase II: Decreasing

Returns to a Factor
 1 4 40 8

1 5 40 0

1 6 35 -5 Phase III: Negative

Returns to a Factor

Phases of Law of Variable Proportion

Phase I: Increasing Returns to a Factor (TP increases at an
increasing rate)

In the initial stage, each additional variable component raises the total
production by an increasing amount. This indicates that each variable’s MP
rises and that TP rises at an increasing rate.
● It occurs as a result of the initial variable input quantity being too
small in comparison to the fixed input. Due to the division of
labour, efficient use of the fixed input during manufacturing
increases the productivity of the variable input.
● One labour generates 5 units, as shown in the schedule and
diagram, whereas two labours produce 20 units. It means that MP
rises until it reaches its maximum point at point P, which signifies
the end of the first phase, while TP rises at an increasing rate (up
to point Q).

Point of Inflexion: A point from where the slope of TP curve changes is

known as point of inflexion. Till the point of inflection, TP increases at an
increasing rate, and from this point downwards, it increases at a
diminishing rate.

Phase II: Decreasing Returns to a Factor (TP increases at a

decreasing rate)

Every extra variable in the second phase increases the output by a less
and smaller amount. This indicates that when the variable factor increases,
MP decreases, and TP rises at a decreasing rate. This stage is known as
the diminishing returns to a factor.
● This occurs as a result of pressure on fixed inputs that results in a
decline in variable input productivity after a certain level of output.
● When MP is zero (point S), and TP is at its maximum (point M) at
40 units, the second phase comes to an end.
 ● The second phase is highly important because a rational producer
will always try to produce during this time because MP and TP are
both positive for each variable factor.

Phase III: Negative Returns to a Factor (TP falls)

The third phase shows a decline in TP due to the use of more variable
factors. MP has now become negative. As a result, this stage is referred to
as negative returns to a factor.
● It occurs when the amount of variable input exceeds the fixed
input by a great difference, which causes TP to decrease.
● The third phase in the above graph begins after points S on the
MP curve and M on the TP curve.
● In the third phase, MP for each variable factor is negative.
Therefore, no company would deliberately decide to operate at
this phase.

Reasons for Variable Proportion

The reasons for the three phases of the law of variable proportions are:

A. Reasons for Increasing Returns to a Factor (Phase I)

The operation of increasing returns to a factor is carried out for three key
reasons:

1. More Effective Use of Fixed Factor: In the initial stage, a number of

fixed factors are available, while there aren’t enough variable factors. The
fixed factor is therefore not completely utilised. The fixed factor is better
used, and output increases at an increasing rate when the variable factors
are increased and combined with fixed factors.
2. Increased Efficiency of Variable Factor: The variable factors must be
increased and combined with the fixed factor, in order to use the former
more efficiently. Besides, there is a high degree of specialisation and
increased cooperation among the different units of the variable factors.

3. Fixed Factor Indivisibility: In general, fixed factors that are integrated

with variable factors are not divisible. It means that these elements cannot
be divided into smaller parts. As more units of the variable components are
given, the utilisation of the fixed factor improves after an investment has
been made in an indivisible fixed factor. As long as the ideal level of
variable and fixed factor combination is attained, increasing returns is
applicable.

B. Reasons for Decreasing Returns to a Factor (Phase II)

The occurrence of diminishing returns to a factor is due to these three key

reasons:

1. Optimum Combination of Factors: There is only one optimal

combination between a variable and a fixed factor where the overall
product is maximum. The marginal return of the variable factor begins to
decrease after the fixed factor has been utilised to its fullest potential. For
instance, if a machine (fixed factor) is being used to its full potential with 4
workers, adding a fifth worker will only slightly improve TP, and MP will
begin to decline.

2. Over-utilization of Resources: The fixed component finally reaches its

limits and begins to produce diminishing returns as one continues
increasing the variable factor.

3. Imperfect Substitutes: Fixed and variable factors are imperfect

substitutes for one another, which results in diminishing returns to a factor.
There is an extent to which one factor of production can be substituted for
another. For instance, until a certain point, capital may be used in place of
labour or labour may be used in place of capital. Beyond a certain point,
they start to lag behind each other and produce declining returns.

C. Reasons for Negative Returns to a Factor (Phase III)

The occurrence of negative returns to a factor is due to these three major

reasons:

1. Limitation of Fixed Factor: The reason why some production factors

have negative returns is that they are fixed in nature and cannot be raised
in the short run together with an increase in the variable factor.

2. Lack of Coordination: When the variable factor dominates the fixed

factor, they interfere with one another. It causes a lack of coordination
between the fixed and the variable factor. As a result, total output falls
rather than rises, and the marginal product becomes negative.

3. Decrease in Efficiency of Variable Factor: The benefits of

specialisation and the division of labour begin to diminish as variable
factors continue to increase. It causes inefficiencies of variable factors,
which is another element that finally leads to negative returns.

Economies of Scale: Definition

Economies of scale refer to the cost advantages that a business or organisation can
achieve as it increases the scale of its operations. In simpler terms, the more a
company produces, the lower the cost per unit.

This is because fixed costs, such as rent and salaries, can be spread out over a
larger output, leading to lower average costs incurred by small businesses.
Economies of scale can be achieved in various ways, including the use of
specialised equipment, negotiating better prices for raw materials, and spreading
advertising and marketing costs over a larger output.

Key Highlights

● Economies of scale happen when an increase in output quantity reduces the

per unit total cost of production.
● Economies of scale occur from operational efficiencies that improve with
increased scale of production.
● Economies of scale can occur from various sources, including purchasing in
bulk, improvement in management quality, and improvements or utilisation of
technologies that increase efficiency.
Effects of Economies of Scale on Production Costs

1. It reduces the per-unit fixed cost. As a result of increased production, the fixed
cost gets spread over more output than before.
2. It reduces per-unit variable costs. This occurs as the expanded scale of
production increases the efficiency of the production process.
The graph above plots the long-run average costs (LRAC) faced by a firm against its
level of output. When the firm expands its output from Q1 to Q2, its average cost
falls from C1 to C2. Thus, the firm can be said to experience economies of scale up
to output level Q2.

In economics, a key result that emerges from the analysis of the production process
is that a profit-maximising firm always produces that level of output which results in
the lowest average cost per unit of output.

Types of Economies of Scale

1. Internal Economies of Scale

This refers to economies that are unique to a firm. For instance, a firm may hold a
patent over a mass production machine, which allows it to lower its average cost of
production more than other firms in the industry.

2. External Economies of Scale

These refer to economies of scale enjoyed by an entire industry. For instance,

suppose the government wants to increase steel production. In order to do so, the
government announces that all steel producers who employ more than 10,000
workers will be given a 20% tax break.

Thus, firms employing less than 10,000 workers can potentially lower their average
cost of production by employing more workers. This is an example of an external
economy of scale – one that affects an entire industry or sector of the economy.

Sources of Economies of Scale

1. Purchasing: Firms might be able to lower average costs by buying the inputs
required for the production process in bulk or from special wholesalers. By
negotiating with suppliers for volume discounts, the purchasing firm takes advantage
of economies of scale.

2. Managerial: Firms might be able to lower average costs by improving the

management structure within the firm. The firm might hire better skilled or more
experienced managers.

3. Technological: A technological advancement might drastically change the

production process. For instance, fracking completely changed the oil industry a few
years ago. However, only large oil firms that could afford to invest in expensive
fracking equipment could take advantage of the new technology.

● Risk-Bearing: spreading risks out across multiple investors

● Financial: higher creditworthiness, which increases access to capital
and more favourable interest rates
● Marketing: more advertising power spread out across a larger
market, as well as a position in the market to negotiate

Larger companies are often able to achieve internal economies of

scale—lowering their costs and raising their production levels—because
they can, for example, buy resources in bulk, have a patent or special
technology, or access more capital.

Diseconomies of Scale

Diseconomies stem from inefficient managerial or labour policies or

over-hiring. The diseconomies may also be external, like a deteriorating
transportation network.
As firms get larger, they grow in complexity. Such firms need to balance the
economies of scale against the diseconomies of scale. For instance, a firm might be
able to implement certain economies of scale in its marketing division if it increased
output. However, increasing output might result in diseconomies of scale in the firm’s
management division.
Benefits of Economies of Scale
Economies of scale can offer numerous benefits to businesses looking to scale up
and improve profitability. These benefits include:

● Lower Production Costs: As mentioned earlier, economies of scale can

help businesses reduce their production costs per unit, which can lead
to higher profits or lower prices for customers.
● Increase Profitability: By reducing costs and increasing efficiency,
economies of scale can help businesses achieve higher profits over the
long term.
● Offer Lower Prices to Customers: When businesses achieve economies
of scale, they can pass the savings on to customers in the form of lower
prices, which can help them compete more effectively in the market.
● Provide a Competitive Advantage: Businesses that achieve economies
of scale may be able to offer a wider range of products or services at
lower prices than their competitors, which can give them a competitive
advantage.

Drawbacks of Economies of Scale

While economies of scale can offer significant benefits, there are also some
drawbacks that businesses should consider before scaling up. These include:
 ● Decrease Flexibility: As businesses become larger, they may become
less flexible and more bureaucratic, making it harder to adapt to
changing market conditions or customer needs.
● Increase Bureaucracy: As businesses grow, they may need to introduce
more processes and procedures to manage the increased complexity,
which can lead to increased bureaucracy and reduced efficiency.
● Risk of Diseconomies of Scale: In some cases, businesses may
experience diseconomies of scale, which occur when the costs of
production per unit start to increase as output increases.

Economies of scale are a powerful tool for businesses looking to achieve long-term
success and profitability.

By understanding the different types of economies of scale, their benefits and

drawbacks, and the factors that influence them, businesses can make informed
decisions about how to scale up and achieve cost savings.

BREAK EVEN ANALYSIS

A break-even analysis is an economic tool that is used to determine the cost

structure of a company or the number of units that need to be sold to cover
the cost. Break-even is a circumstance where a company neither makes a
profit nor loss but recovers all the money spent.
The break-even analysis is used to examine the relation between the fixed cost,
variable cost, and revenue. Usually, an organisation with a low fixed cost will have a
low break-even point of sale.

Importance of Break-Even Analysis

● Manages the size of units to be sold: With the help of break-even analysis, the
company or the owner comes to know how many units need to be sold to cover the cost.
The variable cost and the selling price of an individual product and the total cost are
required to evaluate the break-even analysis.
● Budgeting and setting targets: Since the company or the owner knows at which point a
company can break-even, it is easy for them to fix a goal and set a budget for the firm
accordingly. This analysis can also be practised in establishing a realistic target for a
company.
● Manage the margin of safety: In a financial breakdown, the sales of a company tend to
decrease. The break-even analysis helps the company to decide the least number of
sales required to make profits. With the margin of safety reports, the management can
execute a high business decision.
● Monitors and controls cost: Companies’ profit margin can be affected by the fixed and
variable cost. Therefore, with break-even analysis, the management can detect if any
effects are changing the cost.
● Helps to design pricing strategy: The break-even point can be affected if there is any
change in the pricing of a product. For example, if the selling price is raised, then the
quantity of the product to be sold to break-even will be reduced. Similarly, if the selling
price is reduced, then a company needs to sell extra to break-even.

Components of Break-Even Analysis

● Fixed costs: These costs are also known as overhead costs. These costs materialise
once the financial activity of a business starts. The fixed prices include taxes, salaries,
rents, depreciation cost, labour cost, interests, energy cost, etc.
● Variable costs: These costs fluctuate and will decrease or increase according to the
volume of the production. These costs include packaging cost, cost of raw material, fuel,
and other materials related to production.

Uses of Break-Even Analysis

● New business: For a new venture, a break-even analysis is essential. It guides the
management with pricing strategy and is practical about the cost. This analysis also gives
an idea if the new business is productive.
● Manufacture new products: If an existing company is going to launch a new product,
then they still have to focus on a break-even analysis before starting and see if the
product adds necessary expenditure to the company.
● Change in business model: The break-even analysis works even if there is a change in
any business model like shifting from retail business to wholesale business. This analysis
will help the company to determine if the selling price of a product needs to change.
Break-Even Analysis Formula
Break-even point = Fixed cost/-Price per cost – Variable cost

Example of break-even analysis

Company X sells a pen. The company first determined the fixed costs, which include
a lease, property tax, and salaries. They sum up to ₹1,00,000. The variable cost
linked with manufacturing one pen is ₹2 per unit. So, the pen is sold at a premium
price of ₹10.

Therefore, to determine the break-even point of Company X, the premium pen will
be:

Break-even point = Fixed cost/Price per cost – Variable cost

= ₹1,00,000/(₹12 – ₹2)

= 1,oo,000/10

= 10,000

Therefore, given the variable costs, fixed costs, and selling price of the pen,
company X would need to sell 10,000 units of pens to break-even.

Methods to Calculate Break-Even Point

This section provides an overview of the methods that can be applied to calculate
the break-even point.

1. Algebraic/Equation Method
The following equation is helpful when finding the break-even point using the
algebraic method:

SP = VC + FC
where

● SP = Sales price
● VC = Variable costs
● FC = Fixed costs

With this in mind, the following equation can be used to find the break-even point (o):

o = SP - VC - FC

2. Contribution Margin Method (or Unit Cost Basis)

It is also possible to compute the break-even point using the contribution margin
method. Let's consider the same figures for ABC Limited used in our example on the
algebraic method.

CM = SP - VC

Importance of Break-Even Point Analysis

Break-even point analysis can be applied to answer many important questions in
business, including:

● What sales volume is required to produce the desired profits?

● What is the minimum level of sales needed to avoid losses?
 ● What effect will changes in fixed and variable costs have on profits?
● How will the change in sales mix in the context of a multiproduct firm
affect profits?
● Which product is most profitable?
● What effect will a simultaneous change in price, cost, and volume have
on profits?

Assumptions Underlying Break-Even Analysis:

(i) All costs can be separated into fixed and variable components,
(ii) Fixed costs will remain constant at all volumes of output,
(iii) Variable costs will fluctuate in direct proportion to volume of output,
(iv) Selling price will remain constant,
(v) Product-mix will remain unchanged,
(vi) The number of units of sales will coincide with the units produced so that there is
no opening or closing stock
(vii) Productivity per worker will remain unchanged,(viii) There will be no change in
the general price level.

Uses of Break-Even Analysis:

(i) It helps in the determination of selling price which will give the desired profits.
(ii) It helps in the fixation of sales volume to cover a given return on capital
employed.
(iii) It helps in forecasting costs and profit as a result of change in volume.
(iv) It gives suggestions for shift in the sales mix.
(v) It helps in making an inter-firm comparison of profitability.
(vi) It helps in determination of costs and revenue at various levels of output.
(vii) It is an aid in management decision-making (e.g., make or buy, introducing a
product etc.), forecasting, long-term planning and maintaining profitability.
(viii) It reveals business strength and profit earning capacity of a concern without
much difficulty and effort.
Limitations of Break-Even Analysis:

1. Break-even analysis is based on the assumption that all costs and expenses can
be clearly separated into fixed and variable components. In practice, however, it may
not be possible to achieve a clear-cut division of costs into fixed and variable types.
2. It assumes that fixed costs remain constant at all levels of activity. It should be
noted that fixed costs tend to vary beyond a certain level of activity.
3. It assumes that variable costs vary proportionately with the volume of output. In
practice, they move, no doubt, in sympathy with the volume of output, but not
necessarily in direct proportions..
4. The assumption that selling price remains unchanged gives a straight revenue line
which may not be true. Selling price of a product depends upon certain factors like
market demand and supply, competition etc., so it, too, hardly remains constant.
5. The assumption that only one product is produced or that product mix will remain
unchanged is difficult to find in practice.
6. Apportionment of fixed cost over a variety of products poses a problem.
7. It assumes that the business conditions may not change which is not true.
8. It assumes that production and sales quantities are equal and there will be no
change in opening and closing stock of finished product, these do not hold good in
practice.
9. The break-even analysis does not take into consideration the amount of capital
employed in the business. In fact, capital employed is an important determinant of
the profitability of a concern.

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