Download Cost of Production: A Comprehensive Analysis of Cost Concepts in Economics and more Schemes and Mind Maps Economics in PDF only on Docsity!
SUPPLY ANALYSIS
Supply of a commodity refers to the various quantities of the commodity which a seller is willing and able to sell at different prices in a given market at a point of time, other things remaining the same. Supply is what the seller is able and willing to offer for sale. The Quantity supplied is the amount of a particular commodity that a firm is willing and able to offer for sale at a particular price during a given time period. Supply Schedule: is a table showing how much of a commodity, firms can sell at different prices. Law of Supply: is the relationship between price of the commodity and quantity of that commodity supplied. i.e. an increase in price will lead to an increase in quantity supplied and vice versa. Supply Curve: A graphical representation of how much of a commodity a firm sells at different prices. The supply curve is upward sloping from left to right. Therefore the price elasticity of supply will be positive. Graph - Supply curve Determinants of Supply:
1. The cost of factors of production: Cost depends on the price of factors. Increase in factor cost increases the cost of production, and reduces supply. 2. The state of technology: Use of advanced technology increases productivity of the organization and increases its supply. 3. External factors: External factors like weather influence the supply. If there is a flood, this reduces supply of various agricultural products. 4. Tax and subsidy: Increase in government subsidies results inmore production and higher supply. 5. Transport: Better transport facilities will increase the supply. 6. Price : If the prices are high, the sellers are willing to supply more goods to increase their profit.
7. Price of other goods: The price of other goods is more than ‘X’ then the supply of ‘X’ will be increased. Elasticity of Supply: Elasticity of supply of a commodity is defined as the responsiveness of a quantity supplied to a unit change in price of that commodity. Kinds of Supply Elasticity : Price elasticity of supply : Price elasticity of supply measures the responsiveness of changes in quantity supplied to a change in price. Perfectly inelastic: If there is no response in supply to a change in price. (Es = 0) Inelastic supply: The proportionate change in supply is less than the change in price (Es =0-1) Unitary elastic: The percentage change in quantity supplied equals the change in price (Es=1) Elastic: The change in quantity supplied is more than the change in price (Ex= 1- ∞) Perfectly elastic: Suppliers are willing to supply any amount at a given price (Es=∞) The major determinants of elasticity of supply are availability of substitutes in the market and the time period, Shorter the period higher will be the elasticity. **Factors Influencing Elasticity of Supply
- Nature of the commodity:** If the commodity is perishable in nature then the elasticity of supply will be less. Durable goods have high elasticity of supply. 2. Time period: If the operational time period is short then supply is inelastic. When the the production process period is longer the elasticity of supply will be relatively elastic.
At a price of 3 units, and only at this price, the quantity which producers are willing to produceand supply is identical to the amount consumers are willing to buy. As a result, there is neithera shortage nor a surplus of commodity X at this price. A surplus causes prices to decline and ashortage causes prices to rise. With neither shortage nor surplus at 3 units, there is no reason forthe actual price of commodity X to move away from this price. This price is called the equilibriumprice. Equilibrium represents a situation from where there is no tendency to change. It is a state ofbalance. Stated differently, the price of X will be established where the supply decisions ofproducers and demand decisions of buyers are mutually consistent. Graphically, the interaction of supply and demand curves will indicate the equilibrium Point (E). If market price is OP1, the quantity demanded by consumers is OQ1, while the quantity whichproducers wish to supply is OQ2. There is thus a surplus of Q1Q2 at this price. It is well known thata surplus leads to a downward pressure on price and so market price will fall. At the lower priceof OP2, the quantity supplied is OQ1, while the quantity demanded is OQ2. There is, therefore,
ashortage at this price, represented by Q1Q2. This shortage tends to put an upward pressure onprice and market price is expected to rise. There is only one price, at which the quantity supplied is equal to the quantity demanded, thereis no surplus or shortage, no rise or fall of price – OPe. It is thus referred to as the equilibriumposition. Applications of supply analysis: In economics, the demand-supply study elucidates the dynamics between buyers and sellers (in a free market). Other applications are as follows: Price Control : When at war, governments use demand-supply analysis to set a price ceiling for each product. The price ceiling is the maximum price of essential goods or services. In order to ensure public wellbeing during pressure situations, this price is kept lower than the equilibrium price. Housing Rent Control : Here, the government ascertains a maximum rental price that can be charged to tenants for occupying houses for rent. Again, the set limit is below the equilibrium for housing rent price. This is done to safeguard lower or middle-income tenants from exploitation. Taxation : The analysis considers the impact of direct and indirect taxes on consumers. When indirect taxes are raised, consumers are burdened. It results in a shift in demand and supply curves. Subsidy : To encourage a particular commodity, the government offers subsidies to manufacturers. Such grants decrease the price of that particular good or service. As a result, there is an increase in both demand and supply. Farm Product Pricing : The fair price of farm yield is also based on demand-supply. In a perfectly competitive market, farmers are price takers, and market forces (demand and supply) are the price makers. However, the government sets a minimum price to protect farmers from losses. Black Market Identification : Black marketers flourish when demand for a commodity is high but the supply is low. They sell products at a price higher than the ceiling price. The demand and supply study reveals such practices. Minimum Wage Legislation : State governments undertake such analyses of labor markets to determine minimum wages. A minimum wage cap protects employees and laborers from exploitation.
hand law of returns to scale explains the pattern of output in the long run as all the units of inputs are increased.
- The production function explains the maximum quantity of output, which can be produced, from any chosen quantities of various inputs or the minimum quantities of various inputs that are required to produce a given quantity of output.
Production function can be fitted the particular firm or industry or for the economy as whole. Production function will change with an improvement in technology. Assumptions: Production function has the following assumptions.
- The production function is related to a particular period of time.
- There is no change in technology.
- The producer is using the best techniques available.
- The factors of production are divisible.
- Production function can be fitted to a short run or to longrun. Cobb-Douglasproductionfunction: Production function of the linear homogenous type is invested by Juntwicksell and first tested by C. W. Cobb and P. H. Dougles in 1928. This famous statistical production function is known as Cobb- Douglas production function. Originally the function is applied on the empirical study of the American manufacturing industry. Cabb – Douglas production function takes the following mathematical form. Y=(AKXL^1 - x) Where Y=output K=Capital L=Labour A,∞=positive constant Assumptions: It has the following assumptions
- The function assumes that output is the function of two factors viz. capital and labour.
- It is a linear homogenous production function of the first degree
- The function assumes that the logarithm of the total output of the economy is a linear function of the logarithms of the labour force and capital stock.
- There are constant returns to scale
- All inputs are homogenous
- There is perfect competition
- There is no change in technology
Three stages of law: The behaviors of the Output when the varying quantity of one factor is combines with a fixed quantity of the other can be divided in to three district stages. The three stages can be better understood by following the table. Fixed factor Variable^ factor (Labour) Totalproduct Average Product Marginal Product 1 1 100 100 - Stage I 1 2 220 120 120 1 3 270 90 50 (^1 4 300 75 30) Stage (^1 5 320 64 20) II 1 6 330 55 10 1 7 330 47 0 Stage 1 8 320 40 - (^10) III Above table reveals that both average product and marginal product increase in the beginning and then decline of the two marginal products drops of faster than average product. Total product is maximum when the farmer employs 6th^ worker, nothing is produced by the 7 thworker and its marginal productivity is zero, whereas marginal product of 8th^ worker is ‘-10’, by just creating credits 8th^ worker not only fails to make a positive contribution but leads to a fall in the total output. Production function with one variable input and the remaining fixed inputs is illustrated as below From the above graph the law of variable proportions operates in three stages. 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. Theaverage 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 b “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. II. Law of Returns to Scale: The law of returns to scale explains the behavior of the total output in response to change in the scale of the firm, i.e., in response to a simultaneous to changes in the scale of the firm, i.e., in response to a simultaneous and proportional increase in all the inputs. More precisely, the Law of returns to scale explains how a simultaneous and proportionate increase in all the inputs affects the total output at its various levels. The concept of variable proportions is a short-run phenomenon as in these period fixed factors can not be changed and all factors cannot be changed. On the other hand in the long-term all factors can be changed as made variable. When we study the changes in output when all factors or inputs are changed, we study returns to scale. An increase in the scalemeansthat all inputs or factors areincreased inthe sameproportion. In variable proportions, the cooperating factors may be increased or decreased and one faster (Ex. Land in agriculture (or) machinery in industry) remains constant so that the changes in proportion among the factors result in certain changes in output. In returns to scale all the necessary factors or production are increased or decreased to the same extent so that whatever the scale of production, the proportion among the factors remains the same. When a firm expands, its scale increases all its inputs proportionally, then technically there are three possibilities. (i) The total output may increase proportionately (ii) The total output may increase more than proportionately and (iii) The total output may increaseless than proportionately. If increase in the total output is proportional to the increase in input, it means constant returns to scale.If increase in the output is greater than the proportional increase in the inputs, it means increasing return to scale. If increase in the output is less than proportional increase in the inputs, it means diminishing returns to scale. Let us now explain the laws of returns to scale with the help of isoquants for a two-input and single
curve called Iso-product curve as shown below. Labour is on the X-axis and capital is on the Y-axis. IQ is the ISO-Product curve which shows all the alternative combinations A, B, C, D, E which can produce 50 quintals of a product. Producer’s Equilibrium: The tem producer’s equilibrium is the counter part of consumer’s equilibrium. Just as the consumer is in equilibrium when be secures maximum satisfaction, in the same manner, the producer is in equilibrium when he secures maximum output, with the least cost combination of factors of production. The optimum position of the producer can be found with the help of iso-product curve. The Iso- product curve or equal product curve or production indifference curve shows different combinations of two factors of production, which yield the same output. This is illustrated as follows. Let us suppose. The producer can produces the given output of paddy say 100 quintals by employing any one of the following alternative combinations of the two factors labour and capital computation of least cost combination of two inputs.
L
Units
K
Units
Q
Output L&LP(3Rs.) Costof labour KXKP(4Rs.) costof capital Totalcost 10 45 100 30 180 210 20 28 100 60 112 172 30 16 100 90 64 154 40 12 100 120 48 168 50 8 100 150 32 182 It is clear from the above that 10 units of ‘L’ combined with 45 units of ‘K’ would cost the producer Rs. 20/-. But if 17 units reduce ‘K’ and 10 units increase ‘L’, the resulting cost would be Rs. 172/-. Substituting 10 more units of ‘L’ for 12 units of ‘K’ further reducescost pf Rs. 154/-/ However, it will not be profitable to continue this substitution process further at the existing prices since the rate of substitution is diminishing rapidly. In the above table the least cost combination is 30 units of ‘L’ used with 16 units of ‘K’ when the cost would be minimum at Rs.154/-.So this is the stage “the producer is in equilibrium”. ECONOMIES OF SCALE Production may be carried on a small scale or o a large scale by a firm. When a firm expands its size of production by increasing all the factors, it secures certain advantages known as economies of production. Marshall has classified these economies of large-scale production into internal economies and external economies. Internal economies are those, which are opened to a single factory or a single firm independently of the action of other firms. They result from an increase in the scale of output of a firm and cannot be achieved unless output increases. Hence internal economies depend solely upon the size of the firm and are different for different firms. External economies are those benefits, which are shared in by a number of firms or industries when the scale of production in an industry or groups of industries increases. Hence external economies benefit all firms within the industry as the size of the industry expands. Causes of internal economies: Internal economies are generally caused by two factors
- Indivisibilities 2.Specialization. 1. Indivisibilities Many fixed factors of production are indivisible in the sense that they must be used in a fixed minimum size. For instance, if a worker works half the time,he may be paid half the salary. But he
The large firm reaps marketing or commercial economies in buying its requirements and in selling its final products. The large firm generally has a separate marketing department. It can buy and sell on behalf of the firm, when the market trends are more favorable. In the matter of buying they could enjoy advantages like preferential treatment, transport concessions, cheap credit, prompt delivery and fine relation with dealers. Similarly it sells its products more effectively for a higher margin of profit. D). Financial Economies: The large firm is able to secure the necessary finances either for block capital purposes or for working capital needs more easily and cheaply. It can barrow from the public, banks and other financial institutions at relatively cheaper rates. It is in this way that a large firm reaps financial economies. E). Risk bearing Economies: The large firm produces many commodities and serves wider areas. It is, therefore, ableto absorb any shock for its existence. For example, during business depression, the prices fall for every firm. There is also a possibility for market fluctuations in a particular product of the firm. Under such circumstances the risk-bearing economies or survival economies help the bigger firm to survive business crisis. F). Economies of Research: A large firm possesses larger resources and can establish it’s own research laboratory and employtrainedresearchworkers.Thefirmmayeveninventnewproductiontechniquesfor increasing its output and reducing cost.
G). Economies of welfare: A large firm can provide better working conditions in-and out-side the factory. Facilities like subsidized canteens, crèches for the infants, recreation room, cheap houses, educational and medical facilities tend to increase the productive efficiency of the workers, which helps in raising production and reducing costs. External Economies. Business firm enjoys a number of external economies, which are discussed below: A). Economies of Concentration: When an industry is concentrated in a particular area, all the member firms reap some common economies like skilled labour, improved means of transport and communications, banking and financial services, supply of power and benefits from subsidiaries. All these facilities tend to lower the unit cost of production of all the firms in the industry. B). Economies of Information The industry can set up an information centre which may publish a journal and pass on information regarding the availability of raw materials, modern machines, export potentialities and provide other information needed by the firms. It will benefit all firms and reduction in their costs. C). Economies of Welfare: An industry is in a better position to provide welfare facilities to the workers. It may get land at concessional rates and procurespecial facilities from thelocal bodies for setting up housing colonies for the workers. It may also establish public health care units,educational institutions both general and technical so that a continuous supply of skilled labour is available to the industry. This will help the efficiency of the workers. D). Economies of Disintegration: The firms in an industry may also reap the economies of specialization. When an industry expands, it becomes possible to spilt up some of the processes which are taken over by specialist firms. For example, in the cotton textile industry, some firms may specialize in manufacturing thread, others in printing, still others in dyeing, some in long cloth, some in dhotis, some in shirting etc. As a result the efficiency of the firms specializing in different fields increases and the unit cost of production falls.
D). Technical Diseconomies: There is a limit to the division of labour and splitting down of production p0rocesses. The firm may fail to operate its plant to its maximum capacity. As a result cost per unit increases. Internal diseconomies follow. E). Diseconomies of Risk-taking: As the scale of production of a firm expands risks also increase with it. Wrong decision by the management may adversely affect production. In large firms are affected by any disaster, natural or human, the economy will be put to strains. External Diseconomies: When many firm get located at a particular place, the costs of transportation increasesdueto congestion. The firmshaveto face considerabledelays in getting rawmaterials and sendingfinished productsto the marketing centers. The localization of industriesmay lead to scarcity of raw material, shortage of various factors of production like labour and capital, shortage of power, finance and equipments. All such external diseconomies tendto raise cost per unit.
Cost Analysis The cost which a firm incurs in the process of production of its goods and services is an important variable for decision making. Total cost together with total revenue determines the profit level of a business concern. In order to maximize profits a firm endeavors to increase its revenue and lower its costs. To this end, managers try to produce optimum levels of output, use the least cost combination factors of production, increase factor productivities and improve organizational efficiency. Cost Concepts Costs play a very important role in managerial decisions involving a selection between alternative courses of action. It helps in specifying various alternatives in terms of their quantitative values. The kind of cost to be used in a particular situation depends upon the business decisions to be made. Costs enter into almost every business decision and it is important to use the right analysis of cost. Hence, it is important to understand what these variousconcepts of costs are, how these can be defined and operationalised. This requires the understanding of the two things, namely, (i) that cost estimates produced by conventional financial accounting are not appropriate for all managerial uses, and (ii) that different business problems call for different kinds of costs. Future and Past Costs Futurity is an important aspect of all business decisions. Future costs are the estimates of time adjusted past or present costs and are reasonably expected to be incurred in some future period or periods. Their actual incurrence is a forecast and their management is an estimate. Past costs are actual costs incurred in the past and they are always contained in the income statements. Their measurement is essentially a record keeping activity. Incremental and Sunk Costs Incremental costs are defined as the change in overall costs that result from particular decisions being made.Incremental costs may include both fixed and variable costs. In the short period, incremental cost will consist ofvariable cost — costs of additional labour, additional raw
