Business Economics 1st Year
LESSON – 3
PRODUCTION ANALYSIS
OBJECTIVES
After going through this chapter, you should be able to
- Understand the meaning of production and production function
- Differentiate between economies and diseconomies of scale
- Know the meaning of supply and its determinants
- Understand the various cost and revenue concepts
- Know the meaning and determination of Break-even point
STRUCTURE
3.1. Meaning of production
3.2. Meaning, importance, assumptions and uses of production function
3.3. Short run and Long run production function
3.3.1 Law of Variable Proportions
3.3.2 Assumptions and Importance
3.3.3 Law of Returns to Scale
3.4. Economies and Diseconomies of scale
3.5. Supply and it’s determinants
3.6. Cost Concepts
3.7. Concepts of Revenue
3.7.1 Revenue curves under Perfect Competition
3.7.2 Revenue curves under Imperfect Competition
3.8. Break-even analysis – Determination and Uses of Break-even Point
UNIT QUESTIONS
3. 1. MEANING OF PRODUCTION
In economics, production refers to the creation of utilities and not the creation of matter. Broadly speaking, it includes the commercial services of distribution like transport, whole sale and retail services which help in making the goods available to the final consumer.
3.2. Meaning, importance, assumptions and uses of production function
The production function expresses a functional relationship between physical inputs and physical outputs of a firm at any particular time period. The output is thus a function of inputs. Mathematically production function can be written as
Q = f (A, B, C, D)
where Q stands for the quantity of output and A, B, C, D) are the various input factors such as land, labour, capital and organisation. Here output is the function of inputs. Hence output becomes the dependent variable and inputs are the independent variables.
Importance
(1) When inputs are specified in physical units, production function helps to estimate the level of production. (2) It becomes isoquants when different combinations of inputs yield the same level of output. (3) It indicates the manner in which the firm can substitute one input for another without altering the total output. (4) When price is taken into consideration, the production function helps to select the least combination of inputs for the desired output. (5) It considers the two types of input-output relationships namely law of variable proportions and laws of returns to scale.
Production function may be of fixed proportion production function and variable proportion production function. In a fixed proportion production function, each level of output requires a unique combination of inputs. On the other hand a variable proportion production function is one in which the same level of output may he produced by two or more combinations of inputs. Again 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. The concept of production function can be explained through a schedule.
Production Function
Output a per unit of time | |||||||
6 | 688 | 892 | 1188 | 1764 | 1530 | 1668 | |
Input of Capital | 5 | 628 | 888 | 1284 | 1248 | 1390 | 1530 |
4 | 560 | 792 | 968 | 1112 | 1248 | 1764 | |
3 | 486 | 688 | 834 | 968 | 1284 | 1188 | |
2 | 396 | 556 | 688 | 792 | 888 | 892 | |
1 | 278 | 396 | 486 | 560 | 628 | 688 | |
1 | 2 | 3 | 4 | 5 | 6 | ||
Input of Labour | |||||||
In the above two-way table, output is produced with some combination of the two inputs labour and capital. Along the left hand side, the varying amounts of capital are listed. It is rising from 1 unit to 6 units. Along the bottom are shown the amount of labour from 1 unit to 6 units. The intersections of’ columns and rows may be called ‘cells’. Each cell reveals the output when certain combination of labour and capital is made. It is clear from the table that when 2 units of labour and 2 units of capital are combined, the output will be 556. At 5 units of labour and 5 units of capital, output will be 1390. Thus output varies when the input combination is varied. In practice, all factors will not be changed. For instance the combination of 6 units of labour and one unit of capital (output 688) gives the same output as that of the combination of 3 units of labour and 2 units of capital or 6 units of capital and one unit of labour. The producer has to make decision about these three combinations giving the same result. In such calculation the producer needs data on the prices of inputs used. The producer has to take into account the availability and productivity of the factors and select the least cost combination of inputs for getting the desired output. Thus the production function gives input-output relationship.
Assumptions
1. The production function is related to a particular period of time.
2. There is no change in technology
3. The producer is using the best technique available.
4. The factors of production are divisible.
5. Production function can be fitted to a short run or to a long run.
Production function has immense utility to the producers and executives in decision-making at the firm level. It has important economic implications for the firm. It aids in two ways namely, (1) how to obtain the maximum output from a given combination of inputs, (2) how to attain a given output from the minimum combined cost of various inputs. With the help of production function the producer can say whether additional employment of a variable input factor promises to be profitable or unprofitable. Additional employment of the variable input is desirable so long as the marginal revenue productivity of a variable factor exceeds its price. When marginal revenue productivity is equal to its price, it is wise for the producer to stop employing additional variable factor input. The production function where all factors are variable is highly useful in making long run decisions. When some factors are fixed and some factors are variable it helps in making short run decisions. When the firm experiences the increasing returns to scale, production function guides the producer to increase the output. Production function is therefore a statement of technical facts which the producer uses to obtain the least cost combination of inputs to produce an output.
3.3. Short run and Long run production function
Production function is very much concerned with the law of variable proportions and law of returns to scale. Law of variable proportions also known as the law of diminishing returns is the analysis of production in agriculture used in the traditional economic theory. This law examines the production function with one factor variable, keeping the quantities of other factors fixed. The concept of variable proportion is a short run phenomenon as in this period fixed factors cannot be changed and all factors cannot be changed. The law of variable proportions has been stated by various economists in the following manner. “When total output or production of a commodity is increased by adding units of variable input while the quantities of other inputs are held constant, the increases in total production become, after some point, smaller and smaller.”
On the other hand, the law of returns to scale describes the relationship between output and the scale of inputs in the long run when all the inputs are increased/decreased in the same proportion. According to this law, all the inputs of production are variable and nothing is fixed. In other words, in the returns to scale, we analyse the effect of doubling, trebling, quadrupling and so on of all the inputs of productive resources on the output of the product. Again when all factor units are increased, total product generally increases at an increasing rate, later at a constant rate and finally at a diminishing rate and these three tendencies have come to be known as increasing returns to scale, constant returns to scale and diminishing returns to scale.
Thus returns to scale may clearly be distinguished from the law of variable proportions. In returns to scale all the necessary factors of production are increased or decreased to the same extent so that whatever the scale of production, the proportion among the factors remains the same. On the other hand if one input is variable and all inputs are fixed the firms production function exhibits the law of variable proportions.
3.3.1 Law of Variable ProportionS
This is the fundamental law of production which consists of three phases, namely the increasing returns, diminishing returns and negative returns stages of production. This law explains how the amount of output changes as the amount of one of the inputs is varied, keeping other inputs as fixed.
Stigler likes to refer to the law as “if equal increments of one input are added, the inputs of other production services being held constant, beyond a certain point the resulting increments of product will decrease, i.e., the marginal product will diminish.”
In this way Benham states that “as the proportion of one factor in a combination of factors is increased, after a point, first the marginal and then the average product of that factor will diminish.”
3.3.2 Assumptions
(1) The state of technology remains constant. (2) Only one factor of input is variable and other factors are kept constant. (3) All units of the variable factor are homogeneous. (4) It is possible to change the proportion of the factors of production. (5) It assumes a short-run situation, for in the long- run all productive services arc variable. (6) The product is measured in physical units.
The law of variable proportions can be explained with the help of Table and a diagram.
Output of Ragi in physical units from five acre land
No. of Workers | Total Product | Average Product | Marginal Product | |
1 | 100 | 100 | 100 | Stage – I |
2 | 220 | 110 | 120 | |
3 | 270 | 90 | 50 | |
4 | 300 | 75 | 30 | Stage – II |
5 | 320 | 64 | 20 | |
6 | 330 | 55 | 10 | |
7 | 330 | 47 | 0 | Stage – III |
8 | 320 | 40 | -10 |
In Table, if the farmer employs only 4 labourers, his total product would be 300 units. As the number of labourers increased from 4 to 5, total product increases to 320 and so on. 3rd column shows average product per worker on the farm and is obtained by dividing column 2nd by the column 1st. 4th column contains marginal product and is obtained by finding out the difference in the total product when one unit more or less is produced. In the above table, marginal product of 3rd worker would he 270-220 50 units. It is clear from the table that both average product and marginal product increase in the beginning and then decline. Of the two, marginal product drops off faster than average product. Total product is maximum when the farmer employs 6th worker; nothing is produced by the 7th worker and hence the marginal productivity of 7th worker is zero. Marginal product of 8th worker is -10; i.e., by just creating crowd, 8th worker not only fails to make a positive contribution but leads to a fall in the total output. The behaviour of the marginal product shows clearly three stages; first it increases; second, it continues to fall; and the third, it becomes negative.
The law of variable proportions is presented in Figure
Stage I: In this stage, total product rises from zero, at an increasing rate up to point A. Beyond A, total product continues to rise at a decreasing rate, as the marginal product falls but is positive. The point ‘A’, where the total product stops increasing at an increasing rate and starts increasing at a diminishing rate is called the point of inflexion. At this point the marginal product is at the maximum. The maximum point on the AP curve is ‘e’ where it coincides with the MP curve. Thus stage I refers to the increasing stage where the total product, the marginal product and average product are increasing. It is the increasing returns stage.
Stage II: In the second stage, the total product continues to increase, but at a diminishing rate until it reaches the point ‘C’ where it completely stops to increase any further. At this the second stage ends. Moreover the second stage shows decreasing average product and marginal product of labour, but they are positive. When total product achieves its highest level at C, marginal product falls to zero. The second stage is the stage o diminishing returns.
Stage III : In this stage the total product declines and therefore the TP curve slopes downwards. The average product decreases still further. Marginal product falls faster than average product. The marginal product becomes negative cutting the X-axis. This stage is called the negative returns stage.
Why Increasing Returns (Stage I)?
In stage I the efficiency of the fixed factor increases as additional units of the variable factors are added to it. This causes the production to increase at a rapid rate. Moreover increasing returns are reaped due to indivisibility of factors like machinery, management and finance and these fixed factors are made to work to their full capacity. To maximise the profit, the producer can continue to increase variable factor as long as the average productivity is increasing. Still another cause of increasing returns comes from higher degree of specialisation. When there is sufficient quantity of the variable factor, it becomes possible to introduce the division of labour which leads to higher productivity and more production.
Why Diminishing Returns (Stage II)?
In stage II fixed factor becomes more and more scarce in relation to the variable factor. Hence any further increase in variable factor beyond the point of optimum level will result in diminishing returns per unit of variable factor. That is the marginal and average products of the variable factor decline during this stage. According to Mrs. Joan Robinson, the factors of production cannot be substituted to any extent. It is the scarcity of factors of production that makes the returns diminish after a point. Just as the average product of the variable factor increases in the first stage when better and fuller use of the fixed indivisible factor is being made, so the average product of the variable factor diminishes in the second stage when the fixed indivisible factor is being worked too hard.
Why Negative Returns (Stage III)?
Negative returns take place due to the fact that amount of variable factor becomes too excessive in relation to the fixed factor with the result that fixed and variable factors get in each other’s way and cause total output to fall instead of rising. As in the stage 1, the marginal product of the fixed factor is negative due to its abundance in relation to variable factor, in stage III the marginal product of variable factor becomes negative due to its abundance in relation to fixed factor.
The Best Stage of Production
Now the question arises in which stage a rational producer will seek to produce. A rational producer will not choose to produce in stage I where he marginal product of the fixed factor is negative. So Stage I is irrational. In the stage I, though the producer is faced with increasing returns, yet the producer can increase his profit by switching to Stage II in which the total product is still rising. Similarly Stage III is irrational. In this stage producer will be incurring greater costs as he is utilising more variable factor, but is simultaneously receiving less return because each additional unit of variable input results in the a decline in total output. Labourer works to reduce revenue. This is irrational. We thus conclude that for a profit maximising producer, stage II is the best stage of production. Regardless of factor cost and product price, the chosen level of input application should be somewhere in the range between maximum AP and zero MP. It should however he noted that the small-scale producer often can only maintain production in stage I if he is to produce at all since he does not have enough resources to expand production into stage II.
Importance: The law of variable proportions is of paramount economic importance. The law has become an accepted truth in economic science. It has universal applicability. This law applies as much to industries as to agriculture. The occurrence of diminishing marginal physical returns after a point has been confirmed by the overwhelming empirical evidence. The law demonstrates the limitation of physical substitutability of the various factors of production. It also explains how the variation of one factor does not bring the same returns in all stages. That is why the law is called the law of non-proportional returns. Since production is basic to every type of economic activity, the law .has profound implications for the population problem, low standard of living, relative prices paid to factors of production, nature and methods of production. The law of variable proportions can be used to analyse the economic problems of the present underdeveloped countries. A fundamental problem of development of these countries is to search out methods of production that suit their factor endowments. They are well advised to evolve and follow labour intensive production process rather than adopting the capital intensive technology. The problem facing developed countries is otherwise. These countries suffer from low average and marginal product of capital relative to labour. The law is helpful to suggest the best choice of production technique for an underdeveloped or a developed economy.
3.3.3 The Law of Returns to Scale
Returns to scale describes what happens to the output of an enterprise when all inputs vary in proportion. The way total output behaves to a change in all the factors of production in same proportion is known as the law of returns to scale. When all inputs are increased in unchanged proportions and scale of production is expanded, producer can experience three types of situations. According to this law, when all factor units are increased, total product generally increases at an increasing rate, later at a constant rate and finally at a diminishing rate-these three tendencies have come to be known as “increasing returns to scale”, “constant returns to scale” and “diminishing returns to scale”.
Assumption
The law assumes that
1. All factors are variable and whatever the scale of production the proportion among the factors remains the same.
2. A worker works with given tools and implements.
3. There is no change in technology.
4. There is perfect competition.
5. The product is measured in physical units.
The laws of returns to scale is illustrated in the following table.
Returns to scale in physical units
S.No | Scale | Total Product in quintals | Marginal Product in quintals | |
1. | 1 worker + 2 acres of land | 4 | 4 | |
2. | 2 workers + 4 acres of land | 10 | 6 | Stage I |
3. | 3 workers + 6 acres of land | 18 | 8 | Increasing returns |
4. | 4 workers + 8 acres of land | 28 | 10 | |
5. | 5 workers + 10 acres of land | 38 | 10 | Stage II |
6. | 6 workers + 12 acres of land | 48 | 10 | Constant returns |
7. | 7 workers + 14 acres of land | 56 | 8 | Stage III |
8. | 8 workers + 16 acres of land | 62 | 6 | Decreasing returns |
9. | 9 workers + 18 acres of land | 66 | 4 | |
In Table, when one worker is employed on 2 acres of land, the total product is 4 quintals. Now to increase output, we double the scale, but the total product increases to more than double (to 10 quintals instead of 8 quintals) and when the scale is trebled, the increase in total product is more than treble (to 18 quintals instead of 12 quintals). When 4 labourers are employed on 8 acres of land, the total product reaches 28 quintals. In other words in stage I, the increase in total product is more than proportional to the increase in all inputs.
Hence in this stage we have increasing returns. If the scale of production is further increased, the total product increases at a constant rate up to a certain point and beyond it the total product increases at a diminishing rate. Accordingly we get three stages in the laws of returns to scale.
In the Figure returns to scale increases from A to B, remains constant from B to C and diminishes from C to D.
Increasing Returns to Scale
Increasing returns to scale means that output increases in a greater proportion than the increase in inputs. If all inputs are increased by 20 per cent and output increases by 50 per cent, then the increasing returns to scale is said to be operating. This can be illustrated in Figure.
|
With two factors, labour on X-axis and capital on Y-axis the scale line OP is drawn passing through origin on the iso-product map. This scale line OP represents different levels of input where the proportion between labour and capital remains constant. The distance between AB; BC; CD; DE and EF are decreasing showing the operation of increasing returns to scale. That is the increase in input (scale) is small as we go up the scale and the output is larger. The output increases more proportionately than the increase in input.
When output is raised from a small level to a larger one, indivisible factors are better utilized and therefore increasing returns are obtained. Returns to scale also increases because of greater possibilities of specialization of labour and machinery. But it comes to an end when the internal and external economies of the firm are counterbalanced by internal and external diseconomies.
Constant Returns to Scale
If a doubling or trebling of all factors causes a doubling or trebling of outputs, returns to scale are constant. Increase in the scale or the amounts of all factors leads to a proportionate increase in output. If all inputs are increased by 20 per cent and output increases by 20 per cent, then constant returns to scale is said to be operating. The constant returns to scale can be explained with the help of the scale line and iso-product map.
It will be seen from Figure that successive equal product curves are equidistant from each other along the scale line OP. When AB = BC = CD = DE, we can understand that a change in the amount of the factors in a certain proporation causes a change in the output in the same proportion. This concept of constant returns to scale refers to a linear and homogeneous production function of the first degree and is important in explaining Euler’s Theorem in the theory of distribution.
Economists are of the view that production function must exhibit constant returns to scale if the factors of production are not scarce and are perfectly divisible. In case of perfect divisibility, factors could be divided by appropriate amounts and any amount of output can be produced with optimum proportion of factors. As a result economies and diseconomies of scale would be non-existent and we would get constant returns to scale.
Decreasing Returns to Scale
Decreasing returns to scale means output increases in a smaller proportion than the increase in inputs, if all inputs are increased by 20 per cent and output increases by 10 per cent, then the decreasing returns to scale is said to be in operation. This can he illustrated in Figure.
In the Figure, the larger gaps between successive iso-product curves indicate the operation of the law of diminishing returns to scale. The distance between AB; BC; CD; DE and EF are increasing showing that the scale has to be increased in larger and larger quantities in order to get the same increase in output, i.e., 100 units. The increase in input is large as we go up the scale and output increases less proportionately than the increase in input.
Diseconomies, both internal and external account for the diminishing returns to scale. Diseconomies of scale are usually explained by the limits to decision-making. When the size of the firm expands it is difficult to coordinate all the activities of the firm. This reduces productivity; output per unit of input falls. Some economists are of the view that diminishing returns to scale is a special case of the law of variable proportions because varying quantities of all inputs are combined with a fixed entrepreneur. In the real world, possibilities of output increasing by more than, equal to or less than proportionately can exist depending upon the nature and stage of variation.
3.4. Economies and Diseconomies of scale
ECONOMIES OF SCALE
The scale of production has an important bearing on the cost of production. Larger the scale of production lower is the average cost of production. The entrepreneur is tempted to increase his scale of production to benefit from economies of scale. These economies are of two types: internal and external economies.
Internal Economies
Internal economies refer to those economies secured by a firm due to an increase in its size of production. These economies are enjoyed by the concerned firms only. The larger the expansion of the size of production of firms, the greater will the internal economies secured by a firm. Internal economies are of several types.
1. Technical Economies
These economies arise with the introduction of technical reforms in the organisation of a firm. When the firm is growing, it can install upto date and latest machinery. It can improve its methods of production. New machines can be installed in the place of old machines. Mechanisation leads to decrease in costs and increase in production.
2. Managerial Economies
A large firm can employ meritorious and skilled labourers in all branches of production. It can introduce division of labour and specialisation in the day-to-day organisation of the firm. As a result it can reap the benefits of division of labour and specialisation. Quality and quantity of output per worker can be increased. Cost of production can be minimised. Energy and time of workers can be saved.
3. Economy of Material
A large firm can utilise its by products in an economical manner. For example a sugar mill can use its waste product molasses for manufacturing Alcohol by starting a separate mill for that purpose. Similarly a diary unit can utilise the spoilt milk for preparing sweets and biscuits. A paper firm can utilise its waste products for preparing inferior quality paper.
4. Economy of Integration
A large firm can integrate or link the different stages of production. In doing so it secures considerable profits. For example, a pharmaceutical firm producing drugs and tonics can transport and distribute its product by buying a van. Similarly a sugar mill owner can produce the necessary sugar cane by himself. So integration of production, marketing and distribution stages will bring huge profits.
5. Economy of Marketing
A large firm can also secure economies of marketing. It can buy the required raw materials at cheaper prices. It can also raise the demand for its output through proper publicity, advertisement and salesmanship. But improving the quality of its products, it can get huge profits.
6. Financial Economies
A large firm can secure credit without any difficulty. It can get loans from banks and other institutions at cheaper rates of interest. Similarly it can sell shares and debentures in the open market. It can also plough back a portion of its profits for investment purposes. It can overcome any financial crisis by using the reserve funds.
7. Risk-Taking Economies
Generally a large firm can take risk and bear uncertainty in business affairs. By adopting product differentiation, it can dispose of its products in the market. It produces different types of commodities and supplies them to different markets. It can recover any loss in one market with the gains coming from other markets. It can secure domestic as well as foreign markets for its products. Diversification of production and marketing increases the ability of the firm to withstand losses. It enjoys financial stability.
8. Economy of Research
A large firm can spend considerable amount on research and experimentation. It can establish its own laboratory and employ well trained research experts. It can invest new methods of production and new products. This is possible due to the expansion of the size of production of a firm.
9. Economy of Increased Dimensions
It is a known fact that the cost of operating large machines is less than that of operating small machines. Increase of dimensions of certain machines brings economies. For example, the construction of a double-decker bus requires less expenditure when compared to that of constructing two single buses. Thus, a large firm can get economies due to increased dimensions.
10. Welfare Economies
A large firm can adopt more welfare schemes for promoting the interest of its workers. This makes the workers to show more interest in their work.
11. Economy of Indivisibilities
Some factors of production are indivisible. Their size can’t be reduced after a minimum size. Machinery, marketing and finance are examples of some indivisible factors. A large firm can utilise the optimum capacity of its machinery. When the demand for its product increases, the same machinery can be used for producing more output. This leads to decreases in cost of production. Similarly, expenses incurred on marketing. advertisement, propaganda and publicity can also be minimised by a large firm. Hence, a large firm will able to secure the economies of indivisibility.
12. Economy of Fixed Costs
A large firm can secure the economy of fixed costs. In the case of buildings, machinery, insurance etc., fixed costs remain the same even though level of production was increased. As a result the advantage fixed costs of large firm will decrease.
External Economies
Economies accrued due to the expansion of industry are described a external economies. These economies arise due to the concentration of industries at a particular place. Generally expansion in the size of firms leads to the expansion of the industry and creation of external economies. External Economies are of different types. These are mentioned as follows:
1. Economies of Concentration
When the industry grows in size, all the firms in the industry get the following economies :
(a) Supplementary industries are established in an area.
(b) Transport facilities are developed and cost of transport decreases.
(c) Credit facilities are available due to the establishment of banks and other financial institutions.
(d) Labourers are available without difficulty since skilled labourers migrate to that area.
(e) Electricity is provided at cheaper rates.
(f) Demand for machinery will increase as large sized machines are used by the firms.
(g) Communication facilities will also develop.
2. Economies of Information
External economies also include economies of information. Research laboratories can be started and experiments can be initiated on common problems faced by the firms. New methods of production can be invented and informed to the producers. Trade journals can be published and circulated among the businessmen. Information regarding the availability of raw materials, marketing prospects, export possibilities etc. can be informed through the trade journals. Special meetings and conferences can be organised and solutions to various problems can be known.
3. Economies of Specialisation
Various firms can introduce division of labour and specialisation. They can produce variety of products. Specialisation - vertical and lateral lines brings several advantages to the industry, For example, the textile mills in Mumbai, Surat Baroda
DISECONOMIES OF SCALE
1. Financial Diseconomies
A firm finds it difficult to secure financial facilities after the optimum size.
2. Marketing Diseconomies
The expansion of a firm beyond the optimum size brings losses. It becomes a problem to transport and distribute its products beyond limit. The cost of transport and distribution may overweigh its marketing economies.
3. Technical Diseconomies
It is not possible for a firm to maintain and utilise upto date machinery and latest tools due to the difficulties of finance and marketing. There will be underutilisation of installed capacity.
4. Risk Taking Diseconomies
Several risks have to be faced by the firm when a firm expands its size of output beyond the optimum level.
5. External Diseconomies
Concentration of industry at a particular place has several disadvantages. it becomes a target for enemies in times of war.
6. Managerial Diseconomies
It is very difficult for a firm to manage and supervise its various productive affairs when its size expands beyond a limit. It may lead to disintegration.
3.5. Supply and it’s determinants
Supply is one of the forces that determines the value of goods in the market. Supply is defined as “how much of goods will be offered for sale at a given time”. Supply, thus means the quantity of goods offered for sale in the market. Just like demand, supply is always at a price for a definite quantity in a given period of time. But there is a difference between supply and stock. Stock is the amount of produce which is stored for future use. But supply is only that part of the stock or production which is offered for sale in the market. The production and the stock are the sources of supply and therefore, they constitute the potential supply. But they are not the actual supply in the market.
The Law of Supply is stated thus ‘Other things remaining the same. as the price of the commodity rises, its supply is extended and as the price falls its supply is contracted”. This simply means that as price rises supply increases and as price falls supply decreases in the market. The usual tendency among the producer is to offer more when the price is high and less when the price is less. Thus supply varies directly with the price, in other words the relationship between supply and price is direct. Hence higher the price, larger is the supply, lower the price, smaller is the supply.
Price (in Rs.) | Quantity supplied in Kgs. |
10 | 200 |
8 | 175 |
6 | 150 |
4 | 105 |
2 | 90 |
Supply Schedule
The supply schedule shows the various amounts of a product which a producer is willing and able to produce and make available for sales in the market at each specific price in a set of possible prices during some given period. Hence the price and quantity supplied are directly related. As a result of this direct relationship between supply and price the supply curve will slope upwards as shown in the Figure.
In the figure, SS’ is the supply curve. It is positive and it slopes upward showing increase in supply for every increase in price.
EXCEPTIONS
Like other laws, the Law of Supply has certain exceptions.
(1) This law is not true of antique goods like goods used by great people like Gandhiji. Since their supply is fixed, they cannot be changed to changing price in the market.
(2) The law does not supply to speculators especially ‘bears’ who sell more at a falling price.
(3) Changes in habits, tastes, fashions, weather conditions and national and international disturbance, affect the supply of goods, irrespective of price changes.
(4) The changes in cost over a long period influence supply, irrespective of price changes.
(5) Sometimes the rise in wage will not increase the supply in labour. The Figure illustrate the backward sloping curve of labour.
In the figure supply curve SS’ is backward sloping. At WN wage rate, the supply of labour is ON. But when wage has increased from WN to W1N1 the supply of labour is reduced to ON1. This is because when the workers feels satisfied, they will work less than before in order to have more leisure.
Determinants of Supply
The supply schedule and the curve are prepared and drawn on certain assumptions. The factors which are likely to “change” the supply should be kept constant. The determinants of supply, except the price factor, have been kept constant. What are the other factors influencing supply?
(i) Number of Firms or Sellers : Supply in a market depends on the number of firms or sellers producing and selling in the market. When the sellers are few, the supply will be small. If they are in large numbers, the supply will also be large.
(ii) State of Technology
(iii) Cost of Production : The cost of production is an important item affecting the supply and so this is assumed to remain constant. Wages, rate of interest, price of machinery and equipment, raw materials, etc., remain unchanged. If the cost of production gets reduced, the supply curve will shift down
(iv) Prices of related goods : It is assumed that supply of a commodity depends purely on its price and not on the prices of other commodities related to it. If prices of related products fall, the firm producing many goods may increase the supply of a particular product even though its price has not gone up.
(v) Price Expectations : It is assumed that the seller sells the commodity or supplies the commodity on the basis of the prevailing prices and he does not expect any change in prices of that commodity. If he feels that future prices will be higher, he will reduce the present supply of the product. If he feels that future prices may fall, he will be tempted to sell more at the current price.
(vi) Natural factors : It is assumed that there is no change in natural factors, as the supply is governed by natural factors like rain, drought, etc. This is more so in agro-industries. Further, monsoon failure may result in the reduction in power generation and it may eventually lead to curtailment of production.
(vii) Labour trouble : It is assumed that there is no labour trouble and consequent strike or lock out reducing the quantity of supply. The productive units are supposed to be working smoothly without any interruption, according to schedule.
(viii) Change in Government Policy : Any change in government policy will affect the supply. A fresh tax or levy of excise duty on a commodity will affect the price of the commodity and as a result the supply will get affected. An increase in tax will reduce the supply and granting of subsidy will increase the supply.
As the above stated factors affect the supply conditions, it is likely that the supply curve may be either pushed up or pushed down. Hence, in order to study the supply in relation to price only, we keep all the above stated factors constant. In that case more will be supplied at higher prices and the law of supply will hold good.
6. Cost concepts
Inputs to the production process have prices and firms incur costs in acquiring them. The total cost of production equal the prices of various inputs multiplied by the quantities of inputs used. Costs rise or fall as more or fewer units are used. Economists put forth different concepts of cost of production.
Money Cost
Money costs refer to the total money expenses incurred by -a firm in the production of a commodity. Money costs include so many elements such as cost of raw materials, wages of labourers, expenses on machines, rent on buildings, interest on borrowed capital. expenses on fuel and power, expenses on transportation and advertisement, insurance charges and all types of taxes, All these expenses can also be called as the total cost of production.
Real Cost
The real cost of a product would be the efforts and sacrifices undergone by the producer in producing that product According to Marshall “The exertions of all the different kinds of labour that are directly or indirectly involved in making it; together with the obstinances or rather the waiting required, for saving the capital used in making it; all these efforts and sacrifices together will be called the real cost of production of the commodity.”
Social Costs and Private Costs
Social costs are the costs which are incurred by the society in producing goods and services. Private cost is the cost of producing a commodity by an individual producer. For instance consider a paper mill that disposes of its wastes in a river. Since the river is not owned by anybody, water use does not cost the paper mill a penny. However fishermen suffer losses which are not reflected in the total cost. Total cost incurred by the paper mill includes both the private cost incurred by using resources such as labour and capital and the damage suffered by fishermen.
It is a cost of ‘displaced alternatives’. It represents only sacrificed alternatives and hence is not recorded in any financial account. It depends on the sacrifice of alternative product that could have been produced. This means that the “cost of using something in a particular venture is the benefit foregone (or opportunity lost) by not using it in its best alternative use. In short the opportunity cost of any commodity is the next best alternative commodity that is sacrificed”.
For example, a farmer who is producing paddy, can also produce sugarcane with the same inputs. Therefore the opportunity cost of a quintal of paddy is the amount of output of sugarcane given up. Benham defines the opportunity cost thus: “The opportunity-cost of anything is the next best alternative that could be produced instead by the same factors or by an equivalent group of factors, costing the same amount of money.”
Short-run and Long-run Costs
It has been traditional in economics to make a distinction between the short-run and the long-run. These terms are used in order to denote the length of time over which a firm has a chance to alter its decisions and they are useful terms for studying market responses to changed conditions.
The short-run is a period of time in which only variable factor can be varied, while fixed factors remain the same. In the short-run the firm can vary its output by varying only labour and raw materials. Fixed factors like capital, equipment can-not be varied. If the firm wants to increase output, it can do so only by overworking the existing plant, by hiring more workers and buying more raw materials. Hence in the short-run the firm cannot enlarge the size of the plant or build a new plant of a larger size.
Long-run refers to a period of time which is long enough to bring about possible variations in all inputs. All fixed factors will be converted into variable factors. Output can be increased by increasing capital equipment or by increasing the size of the existing plant or by building a new plant of a greater productive capacity.
On this basis, cost functions are classified as short-run costs and long- run costs. The short-run costs are divided into short-run fixed cost and short-run variable costs.
Short-run Fixed and Variable Costs
Fixed costs do not vary with the changes in output. Fixed cost arises because certain factors of production are indivisible and they have to be engaged for technical reasons in a certain size. When once engaged, these factors can be used over a period of time. For instance inputs like land, buildings, equipment, machinery, permanent staff of the firm can be employed over a period of time for producing more than one batch of goods. The costs incurred in these are called fixed costs. Therefore fixed cost includes rent on land or buildings, interest on capital, salaries of the permanent staff, certain taxes, depreciation and insurance premia. Fixed costs are independent of output and these costs have to be incurred even if the plant is at a standstill. Fixed costs must be incurred by the firm in the short-run whether the output is small or large. Fixed costs are also known as constant costs or supplementary costs or overhead expenses.
Variable costs vary with the changes in output. If there is no output, variable costs are nil. Variable costs are incurred only when the firm is at work. Since variable costs are function of output, total variable costs increase with the level of output. These variable costs include the cost of raw materials, cost of causal or daily labour, fuel and power cost, cost on hired machines and equipments, cost on current repairs and other services. Variable costs play an important role since they help producer decide how much should be produced or whether he should produce at all. Variable costs are also known as prime costs or direct costs.
The concepts of fixed cost and variable cost are shown in the following figures.
Short run fixed cost curves Short run variable cost curve
Short run total cost curve
The curve in Figure-1 shows that fixed costs do not vary in the short- run. The curve in Figure-2 shows that variable costs do change as the output increases. The shape shown in Figure-3 assumes that initially labour exhibits an increasing marginal productivity but that, after some point, the marginal productivity of labour diminishes, thus causing short- run costs to rise rapidly.
In the short-run total costs of a business is the sum of its total variable costs and total fixed costs. Thus TC = TFC + TVC. Because one component ie the total variable cost (TVC) varies with the change in output. The total cost will also respond to changes in the level of output. Therefore the total cost increases as the level of output rises.
The curve in Figure-3 simply represents the summation of the two curves shown in Figure-1 and Figure-2 Short-run fixed costs determine the zero-output intercept for the curve, whereas the short-run variable cost curve determines the total cost curve’s shape.
Short-run Average and Marginal Cost Curves
Average cost is the unit cost of production. It is the cost per unit of output. In the short-run average total cost (ATC) is the sum of average fixed cost (AFC) and the average variable cost (AVC). The per unit fixed costs are known as the average fixed cost and is defined as
AFC = 
where TFC - total fixed cost
q - number of units of output produced.
Average variable cost (AVC) refers to the variable cost per unit of output. It is the total variable cost divided by the number of units of output produced. Average variable cost is defined as
AVC = 
where
where TVC - total variable cost
q - number of units of output produced.
The average total cost is simply called average cost (AC) which is the total cost divided by the number of units of output produced.
ATC = 
where
where TC - total cost
q - number of units of output produced.
i.e. ATC = 
(TC = TFC +TVC)
(TC = TFC +TVC) ATC = 
ATC = AFC + AVC
The following figures show the shape of AFC, AVC and ATC in short period.
The behaviour of ATC or AC curve depends upon the behaviour of AVC and AFC curves. In the beginning both AFC and AVC fall. So, ATC curve also falls. When AVC curve begins rising, but AFC curve is falling steeply, the ATC curve continues to fall because during this stage the fall in AFC is heavier than the rise in AVC. But as output increases further there is a sharp rise in AVC. In this stage the rise in AVC is heavier than the fall in AFC. Therefore the ATC curve rises after a point. The ATC curve like AVC curve falls first, reaches the minimum value and then rises. Hence AC curve has taken a ‘U’ shape.
Marginal Cost
Marginal cost is defined as the addition made to the total cost by producing an extra unit of output.
The Marginal cost curve is given in the figure-5
e The shape of the marginal cost curve is determined by the law of variable proportion. If increasing returns is in operation, the MC curve will be declining as the cost will fall with the increase in output. When the diminishing returns is in operation, the MC curve will be increasing as it is the situation of increasing cost. The marginal cost will remain constant with the constant returns. Hence the shape of the curve will be a ‘U’ one, showing that marginal cost declines first, remains constant and afterwards increases.
Long run Costs
Long run decisions focus on the scale of operations. Long-run cost curves are subject to the laws of returns to scale as against the short run cost curves which are subject to the laws of variable proportions. In the long-run all factors are variable and there is nothing like fixed cost of production. The scale of production undergoes a change when all costs are variable. Individual factors become divisible in the long-run and therefore, they can be used more economically.
It should be remembered that the long-run total cost is the same as that of long-run total variable cost. There is no long-run fixed cost curve, either total or average, because in the long-run all costs are variable. There is no need to distinguish between long run average variable cost and average cost. They are one and the same. The long-run average and marginal costs are derived from the long run total costs.
Long-run average total cost (LATC) = 
where LTC – Long-run total cost : q – output
Long-run marginal cost (LMC) = 
where 
- Change in long-run total cost
- Change in long-run total cost
q - Change in output. The long-run total cost curve is an envelope of the set of short-run total cost curves.
Figure - 7
The LAC curve depicts the lowest possible average cost of production at different levels of output. It is flattened ‘U’ shaped. This type of curve could exist only when the state of technology remains constant. But the empirical evidence shows that the state of technology is subject to change in the long-run. That is why modern firms face ‘L-shaped’ average cost curve in the long-run.
3.7. Concepts of Revenue
In modern days, every firm, whether large or small produces commodities and services with the purpose of selling them in the market in the minimum time possible and profit thereby. The amount of money which the firm receives by the sale of its output in the market is known as its revenue, The concepts of revenue most commonly used in economics are those of’ total revenue, average revenue and the marginal revenue.
Total revenue refers to the total amount of money that the firm receives from the sale of its products. It is the gross revenue realized by the firm in selling the output. This total revenue will vary with the firm’s output and sales. The total revenue can be calculated by multiplying the quantity of output by the price per unit over a period of time.
Mathematically TR = q.p
where TR refers total revenue; q refers to quantity and p is the price per unit of the commodity.
Average Revenue
Average revenue is total revenue divided by the number of units sold, so as to give the average revenue per unit sold. Obviously the average revenue is the price of the commodity. The price paid by the consumer is the revenue realized by the producer. Supposing a seller sells 100 units of a product and obtains Rs. 1,200 from the sale, his total revenue is Rs. 1,200 and the average revenue is Rs. 12. This is the revenue realized per unit of output. The revenue realized from selling one unit is its price. Hence we may write:
AR = 
P = and So AR = P.
P = and So AR = P. It follows from this that the curve which denotes average revenue in relation to output is identical with the demand curve that relates price to output.
Now the question is whether the average revenue is equal to price always or is it different from price. If the seller sells the various units of the product at the same price, then AR would mean only the price. But when he sells different units at different prices, then the AR will not be equal to price. But in actual life, the different units of product will be sold at the same price and so, the average revenue equals price. In economics we use AR and price as synonyms except in the context of price discrimination by the seller. Since buyer’s demand curve represents the quantities purchased or demanded at various prices of the commodity, it also refers to the average revenue at which the various amounts of the commodity are sold by the seller.
Marginal Revenue
Marginal Revenue is the change in total revenue resulting from an increase in sale by an additional unit of the product in a particular time. It is the increase in total revenue by selling one more unit of the commodity. It can also be expressed that the marginal revenue is the addition made to the total revenue by selling ‘n’ units of a product instead of n-I where ‘n’ is any given number. Here the selling of n units and n-I units is not at different points of time. It does not mean that n-1 units are sold at some time and an extra unit is sold at some time later. The concept of marginal revenue is matter of alternative sales policies at the same period of time. To find out the MR of the hundredth unit, we compare the TR resulting when hundred units are sold over some period of time with the TR that would have resulted if 99 units had been sold over the same period of time.
We may write :
MRn = TRn – TRn-1
Let us take a numerical example. Suppose a producer sells ten units of a product at price Rs. 15 per unit. The total revenue he will be getting equals 10 x Rs. 15. Rs. 150. Supposing he increases sales to eleven units and consequently the price falls to Rs. 14, he will obtain a total revenue of Rs. 154 in selling eleven units. The marginal revenue is Rs. 4. That is, selling of eleventh unit has added only Rs. 4. Why is it that the revenue is not equal to the, price? The reason is this. Consequent on increasing the sale by one unit, the price has come down from Rs. 15 to Rs. 14 and all the eleven units are sold at Rs. 14 only. Formerly the ten units were sold at Rs. 15 and now each unit of the ten has lost one rupee and so those 10 units have lost rupees ten. This loss of Rs. 10 is due to the additional unit sold which by itself has earned Rs. 14. Deducting the loss of
Rs. 10 from the price of the eleventh unit, the net addition caused by the eleventh unit is only Rs. 4 (14-10). Hence the Marginal Revenue is Rs. 4 and it is less than the price at which the additional unit is sold.
Rs. 10 from the price of the eleventh unit, the net addition caused by the eleventh unit is only Rs. 4 (14-10). Hence the Marginal Revenue is Rs. 4 and it is less than the price at which the additional unit is sold.
From this analysis we can infer that the Marginal Revenue can be found out in two ways thus:
(i) Directly by finding out the difference between the total revenue before and after selling the additional unit; or
(ii) We can subtract the loss in revenue on the previous units due to the fall in price on account of the additional unit sold.
If there is no fall in price due to the addition of the unit sold, then there is no loss and the Marginal Revenue will be equal to the price as in the case of perfect competition.
3.7.1 Revenue Curves of the Firm Under Perfect Competition
In perfect competition, the individual firm cannot influence the market price and whatever quantity is produced and sold, it will be for the prevailing market price. Hence the total revenue of the firm would increase proportionately with the output offered for sale. When the total revenue increases in direct proportion to the sale of output, the average revenue would remain constant. Since the market price is constant without any variation due to the changes in units sold by the individual firm, the extra output would fetch the proportionate revenue. So the MR and AR will be equal and constant. This will be equal to the price. In such a case the marginal revenue curve will be a straight line parallel to X axis. The same curve denotes average revenue and it represents the price of the unit sold.
The following Table and the curves show the AR and MR under perfect competition.
Number of units sold | Price or Average Revenue (Rs.) | Total Revenue (Rs.) | Marginal Revenue (Rs.) |
1 | 5 | 5 | 5 |
2 | 5 | 10 | 5 |
3 | 5 | 15 | 5 |
4 | 5 | 20 | 5 |
5 | 5 | 25 | 5 |
6 | 5 | 30 | 5 |
In the Table, Col. 2 shows the price and AR which are equal and constant. The total revenue proportionately varies with the output. The marginal revenue is equal to average revenue and price. This is the case under perfect competition. The AR and MR curves are depicted below:
OP is the price which is equal to AR and MR
3.7.2 Revenue Curves of the Firm under Imperfect Competition
But in the case of imperfect competition, be it monopoly, monopolistic competition or oligopoly, the AR curve of an individual firm will slope downwards, Under imperfect competitions, a firm can sell larger quantities only when it reduces the price. When the output is increased for selling, the average revenue or the price will be declining. So the AR curve will be a declining curve. It will decline in the same fashion as the demand curve.
The following Table gives the Total revenue, Average revenue and Marginal revenue under imperfect competition:
Number of units sold | Total Revenue (Rs.) | Average Revenue or Price (Rs.) | Marginal Revenue (Addition made to TR) (Rs.) |
1 | 10 | 10 | 10 |
2 | 18 | 9 | 8 |
3 | 24 | 8 | 6 |
4 | 28 | 7 | 4 |
5 | 30 | 6 | 2 |
6 | 30 | 5 | 0 |
In the Table, Col. 3 indicates the average revenue or price. As the output is increased from I to 2, 3, 4, etc., the price has to be reduced to get adequate demand and consequently the AR is continuously falling from 10 to 9, 8, 7, etc. When the price comes down, the total revenue realized is increasing at a diminishing rate and after the 5th unit the total revenue does not change. Consequently the marginal revenue diminishes with increase in output. At the sixth unit the MR comes to Zero. If seventh unit is produced and sold, it wifl result in negative marginal revenue.
Based on the Table, the AR and MR curves arc given below
The curves show that AR is declining and MR is also declining. The MR curve lies below the AR curve when AR is 1 MR is also falling and it is falling very steeply.
The AR and MR curves need not be a straight line. They may be either convex or concave to origin. But in all cases the MR curve will always lie below the AR curve as shown above in Figure.
3.8. Break-even analysis – determination and uses of Break-even point
What is Break-Even Analysis?
Break-even analysis is a study of costs, revenues and sales of a firm and finding out the volume of sales where the firm’s costs and revenues will be equal. The Break-even point is that level of sales where the net income is equal to zero. The break-even point is the zone of no-profit and no-loss as the costs equal revenues. The object of break-even analysis is not merely to spot the Break-even point, but to create an understanding about the relationship between costs, revenues and output that could be sold within the competence of the firm. This analysis is an important bridge between business behaviour and the theory of the firm.
Determination of Break-Even Point (BEP)
The BEP of a firm can be found out in two ways. It may be approached in terms of physical units, i.e., volume of output or it may be approached in terms of money value, i.e., the value of sales.
(i) BEP in Terms of Physical Units
This method is convenient for a firm producing a single product. The BEP is the number of units of the commodity that should be sold to earn enough revenue just to cover all the expenses of production. The revenue realised covers all costs, variable as well as fixed. The firm does not earn any profit, nor does it incur any loss. It is the meeting point of total revenue and total cost curve of the firm.
The Break-even point is illustrated below by means of a schedule and a graph.
Output in units | Total Revenue Price Rs. 4/- per unit | Total Fixed cost (Rs.) | Total variable cost (Rs.) | Total cost (Rs.) |
0 | 0 | 300 | 0 | 300 |
100 | 400 | 300 | 300 | 600 |
200 | 800 | 300 | 300 | 600 |
300 | 1200 | 300 | 900 | 1200 |
400 | 1600 | 300 | 1200 | 1500 |
500 | 2000 | 300 | 1500 | 1800 |
600 | 2400 | 300 | 1800 | 2100 |
TOTAL REVENUE, TOTAL COST AND BEP
(Selling price : Rs. 4/- per unit)
Some assumptions are made in illustrating the BEP. The price of the commodity is kept constant at Rs.4/-per unit. That is, perfect competition is assumed. Therefore, the total revenue is increasing proportionately to the output. All the units of output are sold out. The total fixed cost is kept constant at Rs.300/- at all levels of output. The total variable cost is assumed to be increasing by a given amount throughout.
From the table, it is clear that when the output is zero the firm incurs only fixed cost under total cost. When the output is 100 the total cost is Rs.600
(TFC + TVC). The total revenue at that level of output is Rs.400. The firm incurs a loss of Rs.200. Similarly, when the output is 200 the firm incurs a loss of
Rs. 100 as the difference between TR and TC is Rs. 100. At the level of output of 300 units, total revenue is equal to total cost (Rs.1,200). At this level, the firm is working at a point where there is no profit or loss. This is the Break-even point. From the level of 400 units of output, the firm is making profit. This is illustrated in the Figure.
(TFC + TVC). The total revenue at that level of output is Rs.400. The firm incurs a loss of Rs.200. Similarly, when the output is 200 the firm incurs a loss of
Rs. 100 as the difference between TR and TC is Rs. 100. At the level of output of 300 units, total revenue is equal to total cost (Rs.1,200). At this level, the firm is working at a point where there is no profit or loss. This is the Break-even point. From the level of 400 units of output, the firm is making profit. This is illustrated in the Figure.
In the Break-even chart, TFC is total fixed cost; TR is total revenue and TC is total cost. Since TFC is constant at all levels of output, it is parallel to X axis. From the figure, we can see that the Break-even point lies at 300 units of output. Up to 300 units of output the firm will be incurring loss in all units of output as TC is at a higher level, than TR. This is called Loss Zone. Beyond 300 units of output, the firm is realizing profit as TR exceeds TC. At 300 units of output the firm is neither incurring loss nor realizing any profit. It is the Break-even point (BEP) or no-profit, no-loss point of production.
Alternative Method
There is another method of finding out BEP in terms of physical units of output. This is by means of a formula. In this case, we adopt Average Revenue and Average Cost instead of TR and TC. The break-even point is that level of output at which the price of the product (i.e., Average Revenue) covers the average cost. The price should be sufficient to cover not only the average variable cost but also some portion of average fixed cost. The excess of selling price over average variable cost goes towards meeting some portion of the fixed cost. This excess is called contribution margin, i.e., the contribution towards meeting the fixed cost. So, the BEP will be at a point where the total contribution margin is equal to the total fixed cost. The formula is as follows:
Total Fixed Cost
BEP = ————————————
Contribution margin per unit
Contribution margin per unit can be found out by deducting the Average Variable Cost from the Selling Price. So the formula will be:
Total Fixed Cost
BEP = ————————————
Selling Price - AVC
300 (TFC)
BEP = ——————
4 – 3
BEP = 300
The Break-even point on the basis of formula comes to 300 units of output.
(iii) BEP in Terms of Sales Value
The BEP in terms of physical output is suitable only in the case of single product firm. If the firm is producing many products, the BEP can he approached only in terms of money value or total sale value or total revenue. Here also the principle of total contribution margin is made equal to total fixed cost; but the contribution margin is expressed as a ratio to sales.
Total Revenue minus-Total Variable Cost
The contribution margin = ————————————
Total Revenue
In our numerical example on the basis of the schedule, the contribution ratio is 0.25. This is arrived at on the basis of the above formula.
Total Fixed Cost
The Break-Even Point = ————————————
Contribution Ratio
Rs. 300
= ————
0.25
= Rs. 1200/-
The firm in our illustration attains its BEP when its sales are Rs.1,200/-. We can check up the result by finding out total variable and fixed costs where the total revenue is Rs. 1,200/-
Total Revenue - Rs. 1,200
Total Fixed Cost Rs.300
Total Variable Cost Rs.900
Total Cost - Rs. 1,200
Net Profit/Loss - Nil
Assumptions of Break-Even Analysis
The break-even analysis is studied with certain assumptions: (i) the volume of production and the volume of sales are equal. That is to say the firm is able to sell all the units of the commodity produced and there is no change in the closing inventory; (ii) the price is assumed to be constant. (III) all revenue is perfectly variable with the physical volume of output and (iv) all costs are either perfectly variable or absolutely fixed over the entire range of volume of production.
In practice, these assumptions may not hold good. The firm may not be able to sell all the stock produced. The firm may charge lower prices for large sales and the costs may not be perfectly variable. Even the fixed cost need not be fixed for the entire range of production.
Usefulness of Break-Even Analysis
The break-even analysis presents a microscopic picture of the business and it enables the management to find out the profitability region. It highlights the areas of economic strength and weakness of the firm. It guides the management in bringing about increase in profits and to take effective decisions in the context of changes in government policies of taxation and subsidies.
The Break-Even Analysis can be used for the following purposes:
(1) Safety Margin : The Break-even chart will help the management to find at a glance the profit generated at various levels of output. By this the management can take decisions regarding the ‘safety margin’ associated with the proposed volume of output and sales. The safety margin refers to the extent to which the firm can afford a decline in sales before it starts incurring losses.
If the firm is working at loss, the safety margin tells the minimum increase in sales to reach BEP and avoid losses. The safety margin can be found out by the following formula:
(Sales – BEP)
Safety Margin = ————————— x 100
Sales
Let us take the numerical example from the schedule given in our illustration. According to the schedule at the level of 500 units of output and sales, the firm is earning profit. How much the firm can afford a decline in sales before it starts incurring losses? In other words, what is the safety margin? Applying the formula
(500 – 300)
Safety Margin = —————— x 100
500
= 40%
This means that the firm which is now selling 500 units of the commodity can afford a decline in sales up to 40 per cent, i.e., a decline in sales up to 200 units and keep the level of sales at 300 before incurring any loss. The margin of safety may be negative as well, if the firm is incurring any loss. In that case, the percentage tells the extent of sales that should be increased in order to reach the point where there will be no loss.
(2) Target profit : The Break-even analysis will help the management in finding out the level of output and sales in order to reach the target of profit fixed. When a firm fixes some target in profit, this analysis will help in finding out the extent of increase in sales by using the following formula.
Fixed Cost + Target Profit
Target sales volume = ————————————
Contribution Margin Percent
By way of illustration, we can take the schedule given. Suppose the firm wants to fix the profit at Rs.200. From the schedule and graph we can find out that the volume of output and sales should be 500 units, as only at that level the profit reaches Rs.200. If the above formula is applied the answer will be the same, i.e., 500 units.
(3) Change in price : Frequently, in the competitive world, the firm will be faced with problems of taking decisions regarding reduction of prices for the commodity. The management has to consider many points in reducing the price. A reduction of price will result in the reduction of contribution margin. This means that the level of output has to be increased even to get the previous level of profit. Reduction in price need not necessarily result in increased sales, as it depends on the elasticity of demand of the commodity produced by the firm. The firm may not have correct and full information regarding the elasticity of demand for the product. Assuming that it remains constant, the management has to take decision regarding the increase of volume of output in order to maintain the profit level in the context of reduction in price. The formula for determining the new volume of sales, to maintain the same profit with given reduction in price will be as follows:
Total Fixed Cost + Total Profit
New Sales Volume = ——————————————————
New Selling Price — Average Variable Cost
Suppose a firm has a total fixed cost of Rs.8,000 and the profit target is Rs.20,000. If the sales price is Rs.8 and the average variable cost is Rs.4/-, then the total volume of sales should be 7,000 units on the basis of the formula given under ‘Target Profit’. Suppose the firm decides to reduce the selling price from Rs.8 to Rs.7, the new sales volume on the basis of the above formula should be:
8000 + 20,000
New Sales Volume = ———————— = 9,333
7 - 4
By reducing the price from Rs.8 to Rs.7, the firm has to increase the sales from Rs.7,000 to Rs. 9,333 if it wants to maintain the target profit of Rs.20,000. In the same manner, the management can calculate the new volume of sales if it increases the price.
Limitations of Break-Even Analysis
The break-even analysis has certain limitations as the entire data collected rest on the cost and revenue functions.
(i) It is static in character : In the break-even analysis we keep everything constant. The selling price is assumed to be constant and the cost function is linear. In practice it will not be so. Larger volume of output cannot be sold at the same price. In the case of bulky sales, some reduction in price has to be given. Similarly, the cost function will not remain constant at different levels of output.
(ii) Projection of future with the past is not correct : In the break-even analysis, since we keeps the functions ‘constant, we project the future with the help of the past functions. This is not correct. Cost in a particular period may not be caused entirely by the output in the period. For example, maintenance expenses may be the result of past output or preparation for a future output. Further, the relationship between output and selling expense is unstable over the period.
(iii) The assumption that cost-revenue-output relationship is linear is true only over a small range of output. It is not an effective tool for long range use. It is better to restrict the break-even analysis to the budget period of the firm, i.e., a year.
(iv) The profits are a function of not only output but also other factors like technological change, improved management, etc., which have been over-looked in the analysis.
In spite of its drawbacks, the Break-even analysis is a useful tool for the management to take decisions. The chart is only a guide giving a rough indication of the possibilities. It is not a judge giving perfect verdicts based on commonsense.
UNIT QUESTIONS
1. Explain production function.
2. Describe the Law of Variables Proportions.
3. Discuss the Law of Returns to Scale.
4. Give an account of economies and diseconomies of scale.
5. Explain the Law of Supply.
6. Explain the various concepts of costs.
7. What do you mean by Break-even Point?
8. What are the different methods of finding Break-even Point?
9. Point out the uses and limitations of Break-even point.
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