B.Tech (CSE)

HSMC - 02

Economics for Engineers

Book - 1 

Book - 2 

MCQ's and fill in the blanks Unit - I Unit - II Unit - III Unit - IV Unit - V Unit- VI

Question Bank - Unit - I Unit - II Unit - III Unit - IV Unit - V Unit- VI

Previous Year Questions

2023 2024

Introduction

Economics for Engineers

"Economics is the science of wealth." - Adam Smith, often considered the father of modern economics, defined economics as the study of how nations manage their wealth, including production, distribution, and consumption of goods and services.

Adam Smith

"Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses." - Lionel Robbins emphasized the allocation of scarce resources to satisfy unlimited wants.

Lionel Robbins

"Economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions." - John Maynard Keynes highlighted the analytical and methodological aspects of economics in understanding economic activities and policies.

John Maynard Keynes

"Economics is the science of human behavior in its actual context, studying how institutions affect economic behavior and outcomes." - Thorstein Veblen focused on the role of social institutions in shaping economic behavior.

Thorstein Veblen

"Economics is the study of individual decision-making units, such as consumers and firms, and how they allocate resources and interact in markets." - This definition emphasizes the micro-level analysis of economic agents and their interactions within markets.

Role of Economics in Engineering

Economics plays a vital role in engineering by helping engineers make cost-effective, efficient, and sustainable decisions in various projects. Below are some key ways in which economics influences engineering:

1. Cost-Benefit Analysis (CBA) – Engineers use economic principles to evaluate the feasibility of projects by comparing costs and expected benefits, ensuring optimal resource utilization.

2. Resource Allocation – Economics helps engineers allocate limited resources efficiently, such as labor, materials, and capital, to maximize productivity and minimize waste.

3. Project Budgeting and Cost Estimation – Economic principles guide engineers in estimating costs, preparing budgets, and controlling expenditures to keep projects financially viable.

4. Market Demand and Feasibility Studies – Engineers assess economic demand before designing or manufacturing products to ensure their commercial success.

5. Optimization of Production Processes – Economic analysis helps engineers design systems and processes that minimize costs while maximizing efficiency and output.

6. Risk Assessment and Management – Economic risk analysis aids engineers in identifying potential financial risks, uncertainties, and mitigation strategies in projects.

7. Sustainability and Environmental Economics – Engineers apply economic principles to develop eco-friendly solutions that balance environmental impact with economic viability.

8. Engineering Management and Decision-Making – Economic knowledge is crucial in managing engineering firms, setting prices, and making strategic business decisions.

9. Infrastructure Development – Economic considerations guide engineers in designing public infrastructure projects such as roads, bridges, and utilities, ensuring cost-effectiveness and long-term sustainability.

10. Innovation and Technology Development – Economics influences research and development (R&D) investments, helping engineers innovate while considering market trends and cost constraints.

In summary, economics enables engineers to make informed decisions that lead to efficient, cost-effective, and sustainable engineering solutions.

Economics for engineers involves applying economic principles and methods to analyze and solve problems in engineering. It covers areas such as cost estimation, financial analysis, project evaluation, resource allocation, and decision-making under uncertainty. Engineers use economic concepts to optimize designs, manage budgets, evaluate the feasibility of projects, and ensure efficient use of resources. This interdisciplinary approach helps engineers make informed choices that balance technical performance with economic viability.

Microeconomics:- Microeconomics is the branch of economics that studies individual economic units, such as consumers, firms, and industries. It focuses on the following: 1. Demand and Supply: Analyzing how prices and quantities of goods and services are determined in markets. 2. Consumer Behavior: Understanding how individuals make decisions to allocate their limited resources. 3. Production and Costs: Examining how firms decide on the quantity of labor and capital to use and how these choices affect costs and output. 4. Market Structures: Investigating different types of market organization (perfect competition, monopoly, oligopoly, and monopolistic competition) and their impact on prices and output. 5. Pricing Mechanisms: Studying how prices are set for goods and services and the role of prices in resource allocation. 6. Elasticity: Measuring how much the quantity demanded or supplied responds to changes in price, income, or other factors. 7. Welfare Economics: Assessing the economic well-being of individuals and society and the effects of economic policies on welfare. Macroeconomics:- Macroeconomics is the branch of economics that examines the economy as a whole. It focuses on aggregate economic variables and phenomena, including: 1. Economic Growth: Analyzing factors that determine the rate at which a country’s economy grows over time. 2. Inflation: Studying the causes and consequences of rising price levels in the economy. 3. Unemployment: Investigating the reasons for joblessness and the measures to reduce it. 4. Gross Domestic Product (GDP): Measuring the total value of goods and services produced within a country. 5. Fiscal Policy: Examining government spending and taxation and their impact on the economy. 6. Monetary Policy: Analyzing the role of central banks in controlling the money supply and interest rates. 7. International Trade: Studying trade between countries, the balance of payments, and the impact of trade policies. 8. Business Cycles: Understanding the fluctuations in economic activity over time and the phases of expansion and contraction. 9. Aggregate Demand and Supply: Investigating the total demand and total supply in the economy and how they interact to determine overall economic activity. 10. Policy Implementation: Assessing the effectiveness of economic policies in achieving macroeconomic goals such as stability, growth, and full employment.

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Relationship between science and engineering: - The relationship between science and engineering is closely interconnected and symbiotic. Here are the key points illustrating this relationship:

1. Foundational Knowledge:

•  Science: Provides fundamental principles and theories that explain natural phenomena.
• Engineering: Applies these scientific principles to create practical solutions and innovations.

2. Research and Development: 

• Science: Focuses on discovering new knowledge and understanding the natural world.
• Engineering: Uses scientific research to develop new technologies, materials, and processes.

3. Problem-Solving:-

• Science: Identifies and explores new problems and questions about how the world works.
• Engineering: Solves specific problems by designing and implementing effective solutions based on scientific knowledge.

4. Methodology:

• Science: Utilizes the scientific method to hypothesize, experiment, observe, and conclude.
• Engineering: Employs the engineering design process, which includes defining problems, brainstorming, prototyping, testing, and iterating.

5. Innovation and Progress:

• Science: Drives progress through discoveries that expand our understanding of the universe.
• Engineering: Translates scientific discoveries into new technologies and systems that improve quality of life.

6. Interdisciplinary Collaboration:

• Science: Often requires engineering expertise to develop experimental apparatus and technologies.
• Engineering: Relies on scientific insights to push the boundaries of what is technically feasible.

7. Education and Training:

• Science: Educates individuals about the natural laws and theories that govern the universe.
• Engineering: Trains individuals to apply this knowledge practically, often involving specialized technical skills.

8. Economic and Social Impact:-

• Science: Enhances our understanding and can lead to societal shifts through new knowledge.
• Engineering: Directly impacts society by creating products, infrastructure, and technologies that shape modern life.

 9. Iterative Feedback Loop:

• Science: New scientific discoveries often lead to new engineering applications.
• Engineering: Engineering innovations can open up new fields of scientific inquiry.

Science and engineering are complementary disciplines. Science seeks to understand the underlying principles of the universe, while engineering applies that understanding to solve practical problems and create new technologies.

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Relationship Between Science, Engineering, Technology, and Economic Development:- Science, engineering, technology, and economic development are closely interconnected, with each playing a critical role in driving progress and enhancing the quality of life. Here’s how they relate to each other:

1. Science:

Definition: The systematic study of the natural world through observation and experimentation, leading to the development of theories and knowledge.

Role in Economic Development: Scientific discoveries and advancements provide the foundational knowledge necessary for technological innovations. For example, breakthroughs in physics, chemistry, and biology have led to new materials, medical treatments, and energy solutions, all of which contribute to economic growth.

2. Engineering:

Definition: The application of scientific principles to design, build, and maintain structures, machines, and systems.

Role in Economic Development: Engineers translate scientific knowledge into practical applications, creating infrastructure, technology, and products that drive economic activities. Engineering advancements improve efficiency, productivity, and quality of life, from building transportation networks to developing advanced manufacturing processes.

3. Technology:

Definition: The application of scientific knowledge for practical purposes, especially in industry. It encompasses tools, machines, techniques, and systems that solve problems and enhance human capabilities.

Role in Economic Development: Technological innovation is a key driver of economic growth. It leads to new industries, improves existing ones, increases productivity, and creates jobs. For instance, the advent of information technology has revolutionized business practices, communication, and access to information, leading to significant economic benefits.

4. Economic Development:

Definition: The process by which the economic well-being and quality of life of a nation, region, or community are improved. It typically involves growth in income, education, infrastructure, and employment opportunities.

Role of Science, Engineering, and Technology: Economic development relies on the continuous advancement of science, engineering, and technology. Investments in these areas lead to innovations that enhance productivity, create new markets, and improve health and education. This, in turn, attracts further investment and fosters a cycle of growth and development.

Interrelationships:

Innovation Cycle: Scientific research leads to new discoveries, which engineers use to develop new technologies. These technologies are then applied in various industries, driving economic growth. For example, the development of the internet (technology) was based on scientific research in computer science and engineering, leading to new businesses and industries (economic development).

Productivity and Efficiency: Advances in engineering and technology improve the efficiency and productivity of various economic sectors. Automated manufacturing processes, advanced agricultural techniques, and efficient transportation systems are all outcomes of engineering innovations that boost economic output.

Quality of Life: Technological advancements in healthcare, education, and communication directly improve the quality of life, leading to a more skilled and healthier workforce, which in turn supports economic development.

Global Competitiveness: Nations that invest in science, engineering, and technology are better positioned to compete globally. They can produce high-value goods and services, attract investment, and maintain economic stability and growth.

Science provides the knowledge, engineering applies this knowledge, technology delivers practical tools and solutions, and together they drive economic development by improving productivity, creating new industries, and enhancing the quality of life. This synergy fosters a sustainable and dynamic economy.

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Nature of Economics , Production Possibility Curve Notes 

Question Bank on Module 1 

Notes for Preparation 

Important Questions

UNIT - 2

Notes

Time value of Money  

Numericals on time Value of Money

1. Future Value Calculation

Problem:
You invest $2,000 in an account that offers an annual interest rate of 5%, compounded annually. What will be the future value of this investment after 10 years?

Solution:

• Given: $PV=2000$,         $r=0.05$,        $n=10$
• Formula: $FV=PV\times (1+r{)}^n$
• Calculation: $$FV=2000\times (1+0.05{)}^{10}=2000\times 1.628895=3257.79$$
• FV=2000×(1+0.05)10=2000×1.628895=3257.79

Answer: The future value of the investment after 10 years is approximately $3,257.79.

2. Present Value Calculation

Problem:
You are promised $5,000 to be received in 7 years. If the discount rate is 8% per year, what is the present value of this future amount?

Solution:

• Given: $FV = 5000$ $r = 0.08$, $n = 7$
  
• Formula: $PV = \frac{FV}{(1 + r)^n}$
• Calculation: $$PV = \frac{5000}{(1 + 0.08)^7} = \frac{5000}{1.7137} = 2917.97$$

Answer: The present value of $5,000 to be received in 7 years is approximately $2,917.97.

3. Interest Rate Calculation

Problem:
You invested $1,000, and it grew to $1,500 in 6 years. What is the annual interest rate?

Solution:

• Given: $PV = 1000$, $FV = 1500$, $n = 6$
• Formula: $FV = PV \times (1 + r)^n$
  Rearrange to solve for $r$: $$r = \left(\frac{FV}{PV}\right)^{\frac{1}{n}} - 1$$
• Calculation: $$r = \left(\frac{1500}{1000}\right)^{\frac{1}{6}} - 1 = (1.5)^{\frac{1}{6}} - 1 = 0.0697 \text{ or } 6.97\%$$

Answer: The annual interest rate is approximately 6.97%.

Capital Budgeting :- Capital Budgeting decision is considered most important and most critical decision for finance manager. It involves decisions related to long-term investments of capital nature. The returns from such investments are scattered over a number of years. Since it requires huge amount of funds, it is considered irreversible.

Some examples of capital budgeting decisions are Purchase of new plant and machinery, replacement of old plant and machinery, expansion and diversification decision, research and development projects etc.

According to Charles T. Horngren:

“Capital Budgeting is long-term planning for making and financing proposed capital outlays.”

According to L.J. Gitman:

“Capital Budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives.”

The process of Capital Budgeting:- 

The process of capital budgeting involves following steps

1. Project Generation: In the first step, projects for investments are identified. This projects may be undertaken to increase revenue or to reducing cost. for this, proposals for expanding production capacity, proposals for replacement of plant etc. could be undertaken.
2. Project Evaluation: In this step, costs and benefits from such projects are evaluated. Projects are judged on the basis of profitability and returns it offers to the firm.
3. Project Selection: The projects generated and evaluated are then screened at various levels of management. After screening, the top management may decide whether to select or reject the proposal.
4. Project Execution: A project is executed after final selection is made by the management. Required funds are allocated to execute the project.
5. Follow-up: Executed projects are then followed-up. Actual performance of the project is compared with the expected performance and deviations are found out. With the help of which future decisions are taken.

Capital Budgeting:- The decision of investing funds in the long term assets is known as Capital Budgeting. Thus, Capital Budgeting is the process of selecting the asset or an investment proposal that will yield returns over a long period.

The first step involved in Capital Budgeting is to select the asset, whether existing or new on the basis of benefits that will be derived from it in the future.

The next step is to analyze the proposal’s uncertainty and risk involved in it. Since the benefits are to be accrued in the future, the uncertainty is high with respect to its returns. Finally, the minimum rate of return is to be set against which the performance of the long-term project can be evaluated.

Working Capital Management:- The working capital management deals with the management of current assets that are highly liquid in nature.

The investment decision in short-term assets is crucial for an organization as a short term survival is necessary for the long-term success. Through working capital management, a firm tries to maintain a trade-off between the profitability and the liquidity.

In case a firm has an inadequate working capital i.e. less funds invested in the short term assets, then the firm may not be able to pay off its current liabilities and may result in bankruptcy. Or in case the firm has more current assets than required, it can have an adverse effect on the profitability of the firm.

Thus, a firm must have an optimum working capital that is necessary for the smooth functioning of its day to day operations.

Techniques of Capital Budgeting:-

Capital budgeting techniques are the methods to evaluate an investment proposal in order to help the company decide upon the desirability of such a proposal. These techniques are categorized into two heads : traditional methods and discounted cash flow methods. 

Traditional Methods:- Traditional methods determine the desirability of an investment project based on its useful life and expected returns. Furthermore, these methods do not take into account the concept of time value of money. 

Pay Back Period Method:- Payback period refers to the number of years it takes to recover the initial cost of an investment. Therefore, it is a measure of liquidity for a firm. Thus, if an entity has liquidity issues, in such a case, shorter a project’s payback period, better it is for the firm. 

Therefore,

Payback period = Full years until recovery + (unrecovered cost at the beginning of the last year)/

Cash flow during the last year:- Here, full years until recovery is nothing but the payback that occurs when cumulative net cash flow equals to zero. Cumulative net cash flow is the running total of cash flows at the end of each time period. 

Average Rate of Return Method (ARR):- Under ARR method, the profitability of an investment proposal can be determined by dividing average income after taxes by average investment, which is average book value after depreciation. 

Thus, ARR = Average Net Income After Taxes/Average Investment x 100

Where, Average Income After Taxes = Total Income After Taxes/Total Number of Years

Average Investment = Total Investment/2

Based on this method,  a company can select those projects that have ARR higher than the minimum rate established by the company. And, it can reject the projects having ARR less than the expected rate of return. 

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Unit III

ppt

Demand

Module -3

Demand: In economics, demand refers to the desire, willingness, and ability of consumers to purchase a good or service at a particular price over a certain period of time. It's a fundamental concept that lies at the core of market economies, driving the production and allocation of resources. Demand not only reflects the preferences of consumers but also their financial capacity to fulfill those preferences.

 

Components of Demand

 

a)     Desire for a Good or Service: At the most basic level, demand begins with the desire for a product or service. However, desire alone doesn't constitute effective demand unless it is backed by the willingness and ability to pay.

b)    Willingness to Pay: This refers to the consumer’s intent to actually spend money on a good or service, as opposed to merely wanting it. It involves a decision-making process influenced by individual preferences, expectations, and budget constraints.

c)     Ability to Pay: Even if consumers want and are willing to purchase a product, they need the financial resources to do so. This aspect of demand takes into account income levels, access to credit, and other financial considerations.

d)    Specific Time Period: Demand is always measured over a specific period of time. For example, the demand for ice cream is typically higher during summer months than in winter. Economists usually specify the time frame to assess and compare demand trends accurately.

 

The Law of Demand:- The law of demand is a fundamental principle in economics that states that, ceteris paribus (all else being equal), the quantity demanded of a good or service falls as its price rises, and vice versa. In other words, there is an inverse relationship between price and quantity demanded.

This relationship is graphically represented by the demand curve, which slopes downward from left to right. The slope reflects that when prices decrease, consumers are more likely to purchase more of the good or service, increasing the quantity demanded.

For example,  Suppose in any economy a commodity price was initially Rs 500/article which rises subsequently as  P2 – Rs 800 and P1 – Rs 1000 due to various price-affecting factors and the rise in price ultimately led to the drop in demand that was initially Q3 – 1000 articles to  Q2 – 700 articles and Q3 – 500 articles as shown in the diagram.

 

The diagram shows that with an increase in the prices of a commodity from P₃ to P₂, the demand for that product decreases from Q₃ to Q₂ and vice versa.

 

The law of demand assumes that other factors (such as consumer income, preferences, and the prices of related goods) remain constant. In reality, these factors often change, leading to shifts in the demand curve.

 

 The Demand Curve:- The demand curve is a graphical representation of the relationship between the price of a good and the quantity demanded. It is usually downward-sloping because, under normal circumstances, consumers tend to buy more of a product when its price falls and less when its price rises.

·       Movement Along the Demand Curve: A movement along the curve occurs when the price of the good changes, leading to a change in the quantity demanded. This is called a "change in quantity demanded."

·       Shifts in the Demand Curve: A shift in the demand curve happens when factors other than the price of the good change. This could be due to changes in consumer income, tastes, or the prices of related goods. A shift to the right indicates an increase in demand, while a shift to the left indicates a decrease.

 

 Types of Demand

 

1)     Individual Demand: This refers to the demand for a product or service by a single consumer. It reflects how much of a good an individual is willing and able to purchase at different prices.

 

2)     Market Demand: Market demand is the sum of all individual demands for a product or service. It represents the total quantity demanded by all consumers in a particular market at various price levels.

 

3)     Derived Demand: Derived demand occurs when the demand for one product is driven by the demand for another product. For example, the demand for steel is derived from the demand for cars and construction projects that require steel as an input.

 

4)     Joint Demand: This happens when two or more products are demanded together because they complement each other. For example, printers and ink cartridges are in joint demand; an increase in the demand for printers usually leads to an increase in the demand for ink cartridges.

 

5)     Composite Demand: Composite demand occurs when a good is demanded for multiple purposes. For instance, crude oil is used to produce gasoline, plastics, and other products. Changes in demand for any of these products can influence the total demand for crude oil.

 

Factors Affecting Demand:- Several factors influence demand in both direct and indirect ways. Understanding these factors helps explain shifts in the demand curve and variations in consumer behavior.

 

1. Price of the Good or Service: The price is the primary factor affecting demand. According to the law of demand, an increase in the price of a good typically leads to a decrease in quantity demanded, while a decrease in price leads to an increase in quantity demanded.

 

2. Income Levels: When consumers experience an increase in income, they are generally able to purchase more goods and services, increasing demand. Conversely, a reduction in income can reduce demand. Income effects vary for different types of goods:

·       Normal Goods: Goods for which demand increases as income rises. For example, as incomes grow, people tend to buy more clothing, electronics, and dining experiences.

·       Inferior Goods: Goods for which demand decreases as income rises. These are often lower-quality substitutes that people buy less of when they can afford better alternatives.

 

3. Prices of Related Goods:

·       Substitute Goods: These are goods that can replace each other. For instance, if the price of tea rises, consumers may switch to coffee, increasing the demand for coffee.

·       Complementary Goods: These are goods that are used together. For example, an increase in the price of cars may reduce the demand for gasoline because fewer cars will be purchased or used.

 

4. Consumer Preferences and Tastes: Changes in consumer preferences, driven by trends, culture, marketing, or personal experiences, can significantly influence demand. For instance, as people become more health-conscious, the demand for organic food has increased.

 

5. Expectations of Future Prices: If consumers expect prices to rise in the future, they may increase current demand to avoid paying higher prices later. Conversely, if they expect prices to fall, they may delay purchases, reducing current demand.

 

6. Population Size and Demographics: A larger population leads to higher demand for goods and services, all else being equal. Additionally, the composition of the population, such as age distribution or income levels, can influence demand for specific products.

 

7. Government Policies: Taxes, subsidies, and regulations can impact demand. For example, a tax on cigarettes might reduce demand, while a subsidy on electric vehicles could increase demand.

 

 

 

 

 

 

 

Elasticity of Demand:- Elasticity of demand helps us to estimate the level of change in demand with respect to a change in any of the determinants of demand. The concept of elasticity of demand helps the firm or manager in decision making with respect to pricing, promotion and production polices. It has a very great importance in economic theory ss well for formulation of suitable economic policy.

Elasticity is the measure of the degree of responsiveness of change in one variable to the degree of responsiveness change in another variable.

 

The concept of elasticity of demand therefore refers to the degree of responsiveness of quantity demanded of a good to the change in its price, consumers income and price of related goods.

 

Types of Elasticity:-

1.     Price Elasticity of Demand: Price elasticity of demand shows the degree of responsiveness of quantity demanded of a good to the change in its price, other factors such as income, prices of related commodities that determines demand for the commodity which are held constant. In other words, price elasticity of demand is defined as the ratio of the percentage change in quantity demanded of a commodity to a percentage change in price of the commodity.

Thus,

 

The demand curve for most of the commodities, is downward sloping due to the inverse relationship between quantity demanded and price of the commodity, the value of the price

elasticity of demand will always be negative. While interpreting the price elasticity of demand the negative sign is ignored or omitted.

This is because we are interested in measuring the magnitude of responsiveness of quantity demanded of a good to changes in its prices.

 

 

 

 

2.     Income Elasticity of Demand: As we have discussed earlier the factor which determines elasticity of demand for a commodity. The consumer’s income is one of the important determinants of demand for a commodity. The demand for a commodity and consumer’s income is directly related to each other, unlike price-demand relationship.

Income elasticity of demand shows the degree of responsiveness of quantity demanded of a commodity to a small change in the income of a consumer. In other words, the degree of

responsiveness of quantity demanded to a change in income is measured by dividing the proportionate change in quantity demanded of a commodity by the proportionate change in the income of a consumer.

 

 

3.     Cross-Price Elasticity of Demand: Sometimes we find two goods are inter-related to each other either they are substitute goods or commentary goods. Cross elasticity of demand measures the degree of responsiveness of demand for one good in responsive to the change in the price of another good.

Classification of goods based on value of cross elasticity of demand:

a)     Substitution: If the value of elasticity between two goods are positive the goods are said to be substitute to each other. For example, Tea and coffee, if the price of tea increases the demand for coffee increases.

b)    Complementary: if the value of elasticity between two goods are negative the goods are said to be complementary. For example, car and petrol, if the price of petrol increases the demand for car decreases.

c)     Unrelated: if the value of elasticity between two goods are zero then the goods are said to be unrelated to each other. For example, table and car, if the price of table increases there is no change in the demand for car.

 

 

 

 

 

 

 

 

 

 

 

 

 

Demand Forecasting: Demand forecasting means estimation of demand for the product for a future period. Demand forecasting enables an organization to take various decisions in business, such as planning about production process, purchasing of raw materials, managing funds in the business, and determining the price of the commodity. A business organization can forecast demand for his product by making own estimations called guess or by taking the help of specialized consultants or market research agencies.

Methods:

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UNIT - IV

Module IV

 

MEANING OF PRODUCTION: The term ‘production’ is very important and broader concept  in economics. To meet the daily demand of a consumer production is essential part. Production is a process by which various inputs are combined and transformed into output of goods and services, for which there is a demand in the market. In other words, Production is a process of combining various material inputs and immaterial inputs in order to make something for consumption. The essences of production are the creation of utilities and the transformation of inputs or resources into output. Inputs are the resources used in the production of goods and services the important resources or input in production are land, labour, capital, and entrepreneur. Production process creates economic well-being into the nation. Thus, production is a process which creates utility and value in exchange.

The theory of production function is concern with the problem in the production process in a certain level of output. It analyses the relation between cost and output and help the firm to determine its profit. All firms that aims at maximising their profit must make their decision regarding production on the bases of the following three decision:

a)     How much output to produce and supply in the market?

b)     How to produce the product, i.e. which technique of production or combination of production to used have to be decided?

c)     How much quantity of input is demanded to produce the output of the product?

Thus, the above three decisions are interrelated and have to be taken by the firm during the production process.

PRODUCTION FUNCTION:- In economics, a production function is the functional relationship between physical output of a production process to physical inputs or factors of production. In other words, production function denotes an efficient combination of input and output. The factors which are used in the production of goods and services are also called as agents of production. Production function of a business firm is determined by the state of technology. More specifically, production function shows the maximum volume of physical output available from a given set of inputs, or the minimum set of inputs necessary to produce any given level of output.

“A production function refers to the functional relationship, under the given technology, between physical rates of input and output of firm, per unit of time”.

Mathematically,

production function can be express as: Q = f (N, L, K, E, T, etc.)

 TYPES OF PRODUCTION FUNCTION

I. The production function can be broadly categorised into two based on the time period i.e.

A) Short run production function: The short run is defined as the period during which at least one of the input is fixed. According to the following short-run production function, labour is the only variable factor input while the rest of the inputs are regarded as fixed. In other words, the short run is a period in which the firm can adjust production by changing variable factors such as materials and labour but cannot change fixed factors such as land, capital, etc. Thus, in short-run some factors are fixed and some are variable.

B) Long run production function: The long run production function is defined as the period of time in which all factors of production are variable. In the long run there is no distinction between the fixed or variable factor as all factors in the long run are variable.

II. The production function can also be classified on the basis of factor proportion i.e.

a) Fixed proportion production function and

b) Variable proportion production function.

 

A. Fixed proportion production function: The fixed proportion production function, also known as a Leontief Production Function which implies the fixed factors of production function such as land, labour , raw materials are used to produce a fixed quantity of an output and these factors of production function cannot be substituted for the other factors. In other words, in such factors of production function fixed quantity of inputs is used to produce the fixed quantity of output. All factors of production are fixed and cannot be substituted for one another.

The concept of fixed proportion production function can be further explained with the help of a Diagram 5.1 as shown below:

B. Variable proportion production function: The variable proportion production function supposes that the ratio in which the factors of production such as labour and capital are used in a variable proportion. Also, the different combinations of factors can be used to produce the given quantity, thus, one factor can be substituted for the other factor. In the case of variable proportion production function, the technical Coefficient of production function is variable, i.e. the important quantity of output can be achieved through the combination of different quantities of factors of production, such as these factors can be varied by substituting one factors to the other/ factors in its place.

The concept of variable proportion production function can be further explained from an isoquant curve, as shown in the Diagram 5.2 below:

In the above diagram, the isoquant curves show that the different combinations of factors of technical substitution shows that it can be employed to get the required amount of output in the production process. Thus, for the production of a given level of product, the input factors can be substituted from another factor input.

 

LAW OF VARIABLE PROPORTION:-  The law of variable proportion is a short run production function theory. This law plays a very important role in the economic theory, which examines the production function with which one variable factor keeping the other factors input fixed. This law is explained by the classical economists to explain the behaviour of agricultural output. In other words, it examines the behaviour of the production in the short-run when the quantity of one factor is varied, keeping the quantity of another factor’s constant. Thus, the law of variable proportion is the new name for the famous theory “The Law of Diminishing Marginal Returns” of classical economist.

Alfred Marshall, had discussed the law in relation to agriculture, according to him, “an increase in the capital and labour applied in the cultivation of land causes in general a less than proportionate increase in the amount of product raised unless it happens to coincide with an improvement in the art of agriculture”.

Marginal productivity of labour in agriculture is zero.

 

Assumptions: The law of variable proportion is based on the following assumptions:

a)     The state of technology is assumed to be given and constant.

b)     There must be some inputs whose quantity must be kept as fixed or constant. Such input factors are called fixed factors.

c)     All units of variable factors inputs are homogenous.

d)     The law is based upon the possibility of varying the proportions in which the various factors can be combined to produce the level of output. Let us assume the labour is the variable factor in our explanation.

Change in output due to increase in variable factors can be explain with the table given below:

Module IV

PRODUCTION FUNCTION

Economies of Scale:  Prof. Stigler defines economies of scale as synonyms with returns to scale. As the scale of production is increased, up to a certain point, one gets economies of scale. there are its diseconomies to scale Marshall has classified economies to scale into two parts as under:

I. Internal Economies: As a firm increases its scale of production, the firm enjoys several economies named as internal economies. Basically, internal economies are those which are special to each firm. For example, one firm will enjoy the advantage of good management; the other may have the advantage of specialization in the techniques of production and so on.

“Internal economies are those which are open to a single factory, or a single firm independently of the action of other firms. These result from an increase in the scale of output of a firm and cannot be achieved unless output increases.” Cairncross

Prof. Koutsoyannis has divided the internal economies into two parts:

    A. Real Economies

    B. Pecuniary Economies

A. Real Economies: Real economies are those which are associated with the reduction of physical quantity of inputs, raw materials, various types of labour and capital etc.

These economies are of the following types:

1. Technical Economies: Technical economies have their influence on the size of the firm. Generally, these economies accrue to large firms which enjoy higher efficiency from capital goods or machinery. Bigger firms having more resources at their disposal are able to install the most suitable machinery.

Therefore, a firm producing on large scale can enjoy economies by the use of superior techniques.

Technical economies are of three kinds:                   

        i.         Economies of Dimension: A firm by increasing the scale of production can enjoy the technical economies. When a firm increases its scale of production, average cost of production falls but its average return will be more.                        

             ii.         Economies of Linked Process: A big firm can also enjoy the economies of linked process. A big firm carries all productive activities. These activities get economies. These linked activities save time and transport costs to the firm.

           iii.   Economies of the Use of By-Products: All the large sized firms are in a position to use its by-products and waste-material to produce another material and thus, supplement to their income. For instance, sugar industries make power, alcohol out of the molasses.

2. Marketing Economies: When the scale of production of a firm is increased, it enjoys numerous selling or marketing economies. In the marketing economies, we include advertisement economies, opening up of show rooms, appointment of sole distributors etc. Moreover, a large firm can conduct its own research to effect improvement in the quality of the product and to reduce the cost of production. The other economies of scale are advertising economies, economies from special arrangements with exclusive dealers. In this way, all these acts lead to economies of large scale production.

3. Labour Economies: As the scale of production is expanded their accrue many labour economies, like new inventions, specialization, time saving production etc. A large firm employs large number of workers. Each worker is given the kind of job he is fit for. The personnel .officer evaluates the working efficiency of the labour if possible. Workers are skilled in their operations which save production, time and simultaneously encourage new ideas.

4. Managerial Economies: Managerial economies refer to production in managerial costs and proper management of large scale firm. Under this, work is divided and subdivided into different departments. Each department is headed by an expert who keeps a vigil on the minute details of his department. A small firm cannot afford this specialisation. Experts are able to reduce the costs of production under their supervision. These also arise due to specialization of management and mechanisation of managerial functions.

5. Economies of Transport and Storage: A firm producing on large scale enjoys the economies of transport and storage. A big firm can have its own means of transportation to carry finished as well as raw material from one place to another. Moreover, big firms also enjoy the economies of storage facilities. The big firm also has its own storage and go down facilities. Therefore, these firms can store their products when prices are unfavorable in the market.

B. Pecuniary Economies: Pecuniary economies are those which can be had after paying less prices for the factors used in the process of production and distribution. Big firms can get raw material at the low price because they buy the same in the large bulk. In the same way, they enjoy a lot of concessions in bank borrowing and advertisements.

These economies occur to a large firm in the following:    

i.   The firms producing output on a large scale purchase raw material in bulk quantity. As a result of this, the firms get a special discount from suppliers. This is a monetary gain to the firms.          

ii. The large-scale firms are offered loans by the banks at a low interest rate and other favourable terms.

iii. The large-scale firms are offered concessional transportation facilities by the transport companies because of the large-scale transportation handling.

iv.  The large-scale firms advertise their products on large scales and they are offered advertising facilities at lower prices by advertising firms and newspapers.

II. External Economies: External economies refer to all those benefits which accrue to all the firms operating in a given industry. Generally, these economies accrue due to the expansion of industry and other facilities expanded by the Government. According to Cairncross, “External economies are those benefits which are shared in by a number of firms or industries when the scale of production in any industry increases.” Moreover, the simplest case of an external economy arises when the scale of production function of a firm contains as an implicit variable the output of the industry. A good example is that of coal mines in a locality.

Prof. Cairncross has divided the external economies into the following parts as:

1. Economies of Concentration: As the number of firms in an area increases each firm enjoys some benefits like, transport and communication, availability of raw materials, research and invention etc. Further, financial assistance from banks and non-bank institutions easily accrue to firm. We can, therefore, conclude that concentration of industries lead to economies of concentration.

2. Economies of Information: When the number of firms in an industry expands they become mutually dependent on each other. In other words, they do not feel the need of independent research on individual basis. Many scientific and trade journals are published. These journals provide information to all the firms which relates to new markets, sources of raw materials, latest techniques of production etc.

3. Economies of Disintegration: As an industry develops, all the firms engaged in it decide to divide and sub-divide the process of production among themselves. Each firm specializes in its own process. For instance, in case of moped industry, some firms specialize in rims, hubs and still others in chains, pedals, tires etc. It is of two types-horizontal disintegration and vertical disintegration.

In case of horizontal disintegration each firm in the industry tries to specialize in one particular item whereas, under vertical disintegration every firm endeavors to specialize in different types of items. Material of one firm may be available and useable as raw materials in the other firms. Thus, wastes are converted into by-products.

The selling firms reduce their costs of production by realizing something for their wastes. The buying firms gain by getting other firms’ wastes as raw materials at cheaper rates. As a result of this, the average cost of production declines.

Significance of Economies of Scale: The significance of economies of scale is discussed as under:

a) Nature of the Industry: The foremost significance of economies of scale is that it plays an important role in determining the nature of the industry i.e. increasing cost industry, constant cost industry or decreasing cost industry.

b) Analysis of Cost of Production: When an industry expands in response to an increase in demand for its products, it experiences some external economies as well as some external diseconomies. The external economies tend to reduce the costs of production and thereby causing an upward shift in the long period average cost curve, whereas the external diseconomies tend to raise the costs and thereby causing an upward shift in the long period average cost curve. If external diseconomies outweigh the external economies, that is, when there are net external diseconomies, the industry would be an Increasing cost industry.