Economics FOR engineers

Econ0mics
Section-a
• Economics is the study of how people allocate scarce resources for
production, distribution, and consumption, both individually and
collectively.
• Two major types of economics are microeconomics, which focuses
on the behavior of individual consumers and producers,
and macroeconomics, which examine overall economies on a
regional, national, or international scale.
• Economics is especially concerned with efficiency in production
and exchange and uses models and assumptions to understand
how to create incentives and policies that will maximize efficiency.
• Economists formulate and publish numerous economic indicators,
such as gross domestic product (GDP) and the Consumer Price
Index (CPI).
• Capitalism, socialism, and communism are types of economic
systems.
Definitions
• Economy is the art of making most of life.
- George Bernard Shaw
• Economics is the study of mankind in the ordinary business of life.
- Alfred Marshall
• Economics is the science which studies human behaviour as a relationship
between ends and scarce means which have alternative uses.
- Lionel Robbins
• Economics comes in whenever more of one thing means less of another.
- Fritz Machlup
• The theory of economics is a method rather than a doctrine, an apparatus
of mind, a technique of thinking, which helps its possessor to draw correct
conclusions.
- John Maynard Keynes

• Economics is the study of the use of scarce resources to satisfy unlimited
human wants.
- Richard Lipsey
• The above attempts to define the discipline of economics in a short,
concise sentence indicate that the discipline has both individual and social
dimensions. The discipline straddles the areas of arts and science, of
theory and policy, and provides a fascinating mechanism for interpreting
human behaviour, individually and collectively.
Difference between Microeconomics and Macroeconomics
“Economics is the science which studies human behaviour as a relationship
between given ends and scarce means which have alternative uses.”
Top 7 Difference Between Microeconomics And
Macroeconomics
Economic is a study about how individuals, businesses and governments make
choices on allocating resources to satisfy their needs. These groups determine
how the resources are organised and coordinated to achieve maximum output.
They are mostly concerned with the production, distribution and consumption of
goods and services.
Economics is divided into two important sections, which are: Macroeconomics
& Microeconomics
Macroeconomics deals with the behaviour of the aggregate economy and
Microeconomics focuses on individual consumers and businesses.
What is Microeconomics?
Microeconomics is the study of decisions made by people and businesses
regarding the allocation of resources and prices of goods and services. The
government decides the regulation for taxes. Microeconomics focuses on the
supply that determines the price level of the economy.
It uses the bottom-up strategy to analyse the economy. In other words,
microeconomics tries to understand human’s choices and allocation of
resources. It does not decide what are the changes taking place in the market,
instead, it explains why there are changes happening in the market.
The key role of microeconomics is to examine how a company could maximise
its production and capacity, so that it could lower the prices and compete in its
industry. A lot of microeconomics information can be obtained from the
financial statements.
The key factors of microeconomics are as follows:

• Demand, supply, and equilibrium
• Production theory
• Costs of production
• Labour economics
Examples: Individual demand, and price of a product.
What is Macroeconomics?
Macroeconomics is a branch of economics that depicts a substantial picture. It
scrutinises itself with the economy at a massive scale, and several issues of an
economy are considered. The issues confronted by an economy and the headway
that it makes are measured and apprehended as a part and parcel
of macroeconomics.
Macroeconomics studies the association between various countries regarding
how the policies of one nation have an upshot on the other. It circumscribes
within its scope, analysing the success and failure of the government strategies.
In macroeconomics, we normally survey the association of the nation’s total
manufacture and the degree of employment with certain features like cost prices,
wage rates, rates of interest, profits, etc., by concentrating on a single imaginary
good and what happens to it.
The important concepts covered under macroeconomics are as follows:
1. Capitalist nation
2. Investment expenditure
3. Revenue
Examples: Aggregate demand, and national income.
Top 7 Differences Between Microeconomics And Macroeconomics
Let us look at some of the points of difference between Microeconomics and
Macroeconomics
Microeconomics Macroeconomics
Meaning
Microeconomics is the
branch of Economics that is
related to the study of
individual, household and
firm’s behaviour in decision
Macroeconomics is the branch
of Economics that deals with
the study of the behaviour
and performance of the
economy in total. The most

making and allocation of the
resources. It comprises
markets of goods and
services and deals with
economic issues.
important factors studied in
macroeconomics involve gross
domestic product (GDP),
unemployment, inflation and
growth rate etc.
Area of study
Microeconomics studies the
particular market segment of
the economy
Macroeconomics studies the
whole economy, that covers
several market segments
Deals with
Microeconomics deals with
various issues like demand,
supply, factor pricing,
product pricing, economic
welfare, production,
consumption, and more.
Macroeconomics deals
with various issues like
national income,
distribution, employment,
general price level, money,
and more.
Business Application
It is applied to internal
issues.
It is applied to
environmental and external
issues.
Scope
It covers several issues like
demand, supply, factor
pricing, product pricing,
economic welfare,
production, consumption,
and more.
It covers several issues like
distribution, national income,
employment, money, general
price level, and more.
Significance

It is useful in regulating
the prices of a product
alongside the prices of
factors of production
(labour, land,
entrepreneur, capital,
and more) within the
economy.
It perpetuates firmness in
the broad price level, and
solves the major issues of
the economy like deflation,
inflation, rising prices
(reflation), unemployment,
and poverty as a whole.
Limitations
It is based on impractical
presuppositions, i.e., in
microeconomics, it is
presumed that there is
full employment in the
community, which is not
at all feasible.
It has been scrutinised that
the misconception of
composition’ incorporates,
which sometimes fails to
prove accurate because it
is feasible that what is true
for aggregate
(comprehensive) may not
be true for individuals as
well.
After learning the above concepts, we can come to the conclusion that these two
concepts are not antithetical but complementary to each other and they are
bound to go hand in hand.
What are the Central Problems of an Economy?
After the central problems of an economy introduction, it is important to understand
all the underlined aspects of such problems. Following is a detailed discussion on the
central problems that every economy faces.
• Allocation of Resources
A problem that an economy predominantly faces is the allocation of resources. Due to
the scarcity of available resources, it leads to the troublesome situation of assigning
these limited resources to produce goods and services that can fulfil societal wants
maximally.
Thus, it is important to distribute the resources efficiently so that they can cater to
produce several commodities to satisfy the needs of different socio-economic groups
in various manners.

This decision needs to be taken depending on the three central problems of the
economy.
1. What to produce
2. How to produce
3. For whom to produce
To know the answer to what are the central problems of the economy, the following
discussion is necessary.
1. What to Produce
This problem refers to the decisions regarding the selection of different commodities
and the quantities that need to be produced. Labour, land, machines, capital,
equipment, tools and natural means of resources are limited. So, it is not possible to
fulfil society’s every demand. Therefore, it needs to be decided what goods and
services are required to be produced and what should be the quantity.
Furthermore, the central problems of an economy also depend on the classification of
commodities based on their degree of necessity – luxury and essential.
In an economy, the produced goods are further classified into two segments, namely
consumer goods and producer goods or capital goods. Moreover, both these
segments are again divided into single-use goods and durable goods.
Thus, there are two aspects to the problem, “what to produce” –
• What Types of Goods to be Produced
For example, every economy needs to decide on what consumer goods like rice,
clothes, etc. and what producer goods like tools, machinery, etc. are required to be
produced to meet demand adequately.
• How Much Amount of Goods to be Produced
The next challenge is to decide, in what quantity goods should be produced. It is a
crucial aspect of any economy, as proportionate distribution of resources for the
production of different goods to maximally satisfy wants is quintessential.
2. How to Produce
This problem is about the choice of techniques that need to be adopted and used in
the production of goods and services.
The two majorly-used techniques are-
• LIT or Labour Intensive Techniques
This technique is used with the help of more number of labour and less involvement
of capital.
• CIT or Capital Intensive Techniques

On the other hand, the CIT technique involves more capital involvement and less
utilisation of labour.
For instance, footwear can be manufactured either in factories where a large portion
of manufacturing is carried out by machines or by skilled teams of cobblers.
DIY: In the Above Example, Which Option is Labour Intensive, and Which Option is
Capital Intensive?
The relative price and availability of labour and capital are the determining factors
while selecting the production technique. Moreover, some socio-economic objectives
also need to be fulfilled by choosing the techniques.
Such objectives are providing employment and enhancing the standard of living in
society. For example, in countries like China, LIT is favoured as an ample number of
labours are available. Contrarily, the United Kingdom will prefer CIT due to the
availability of capital and scarcity of labour.
3. For Whom to Produce
One of the most crucial problems of the economy is to decide which commodities shall
be produced for which sections of society.
For instance, essential goods and services are in demand from all sections of society,
but only certain sections of society have a demand for luxury commodities. At the same
time, choices of goods and services rest on prevalent tastes and preferences in an
economy.
Hence, considerations regarding the socio-economic conditions of a country or market
are highly pertinent to this problem.
Lastly, it is important to know that other than resource allocation, central problems of
an economy have two more aspects – efficient utilisation of the resource and
development of resources. Thus, to explain central problems of an economy, one
needs to delve into its core, i.e. choices concerning the limited resources available to
maximise socio-economic utility.
Problem # 1. What to Produce and in What Quantities?
The first central problem of an economy is to decide what goods and services
are to be produced and in what quantities. This involves allocation of scarce
resources in relation to the composition of total output in the economy. Since
resources are scarce, the society has to decide about the goods to be produced:
wheat, cloth, roads, television, power, buildings, and so on.

Once the nature of goods to be produced is decided, then their quantities are
to be decided. How many tonnes of wheat, how many televisions, how many
million kws of power, how many buildings, etc. Since the resources of the
economy are scarce, the problem of the nature of goods and their quantities
has to be decided on the basis of priorities or preferences of the society.
If the society gives priority to the production of more consumer goods now, it
will have less in the future. A higher priority on capital goods implies less
consumer goods now and more in the future. But since resources are scarce, if
some goods are produced in larger quantities, some other goods will have to
be produced in smaller quantities.
This problem can also be explained with the help of the production possibility
curve as shown in Figure 1.
Suppose the economy produces capital goods and consumer goods. In
deciding the total output of the economy, the society has to choose that
combination of capital goods and consumer goods which is in keeping with its
resources.
It cannot choose the combination R which is inside the production possibility
curve PP1 because it reflects economic inefficiency of the system in the form of
unemployment of resources. Nor can it choose the combination R which is
outside the current production possibilities of the society. The society lacks
the resources to produce this combination of capital goods and consumer
goods.
It will, therefore, have to choose among the combinations В, E, or D which
give the highest level of satisfaction. If the society decides to have more capital
goods, it will choose combination B; and if it wants more consumer goods, it
will choose combination D.

Problem # 2. How to Produce these Goods?
The next basic problem of an economy is to decide about the techniques or
methods to be used in order to produce the required goods. This problem is
primarily dependent upon the availability of resources within the economy.
If land is available in abundance, it may have extensive cultivation. If land is
scarce, intensive methods of cultivation may be used. If labour is in
abundance, it may use labour-intensive techniques; while in the case of labour
shortage, capital-intensive techniques may be used.
The technique to be used also depends upon the type and quantity of goods to
be produced. For producing capital goods and large outputs, complicated and
expensive machines and techniques are required. On the other hand, simple
consumer goods and small outputs require small and less expensive machines
and comparatively simple techniques.
Further, it has to be decided what goods and services are to be produced in
the public sector and what goods and services in the private sector. But in
choosing between different methods of production, those methods should be
adopted which bring about an efficient allocation of resources and increase
the overall productivity in the economy.
Suppose the economy is producing certain quantities of consumer and capital
goods at point A on PP curve in Figure 2. у adopting new techniques of
production, given the supplies of factors, the productive efficiency of the
economy increases. As a result, the PP0 curve shifts outwards to P1P1.
It leads to the production of more quantities of consumer and capital gods
from point A on PP0 curve to point С of PP with be the new production
possibility curve and the economy will move from point A to В where more of
both the goods are produced.
Problem # 3. For whom is the Goods Produced?
The third basic problem to be decided is the allocation of goods among the
members of the society. The allocation of basic consumer goods or necessities

and luxuries comforts and among the household takes place on the basis of
among the distribution of national income.
Whosoever possesses the means to buy the goods may have then. A rich
person may have a large share of the luxuries goods, and a poor person may
have more quantities of the basic consumer goods he needs. This problem is
illustrated in Figure 3 where the production possibility curve PP shows the
combinations of luxuries and necessaries.
At point В on the PP curve, the economy is producing more of luxuries ОС for
the rich and less of necessaries ОС for the at whereas at point D more of
necessaries OH are being produced for the poor and less of luxuries OF for the
rich.
Problem # 4. How Efficiently are the Resources being Utilised?
This is one of the important basic problems of an economy because having
made the three earlier decisions, the society has to see whether the resources
it owns are being utilised fully or not. In case the resources of the economy are
lying idle, it has to find out ways and means to utilise them fully.
If the idleness of resources, say manpower, land or capital, is due to their male
allocation, the society will have to adopt such monetary, fiscal, or physical
measures whereby this is corrected. This is illustrated in Figure 4 where the
production possibility curve PP reflects idle resources within the economy at
point A, while the production possibility curve P1P1 reflects the full utilisation
of the resources at point В or C.
It is for the society to decide whether to produce more capital goods at point В
or more consumer goods at point C, or both at point D at the level of full
employment represented by the In an economy where the available resources
are being fully utilised, it is characterised by technical efficiency or full
employment.

To maintain it at this level, the economy must always be increasing the output
of some goods and services by giving up something to others.
Problem # 5. Is the Economy Growing?
The last and the most important problem is to find out whether the economy
is growing through time or is it stagnant. If the economy is stagnant at any
point inside the production possibility curve, says in Figure 5, it has to be
moved on to the production possibility curve PP whereby the economy now
produces larger quantities of consumer goods and capital goods.
Economic growth takes place through a higher rate of capital formation which
consists of replacing existing capital goods with new and more productive
ones by adopting more efficient production techniques or through
innovations.
This leads to the outward shifting of the production possibility curve from PP
to P1P1; (in Figure 5). The economy moves, say after 5 years, from point A to В
or С or D on the P1P1 curve. Point С represents the situation where larger
quantities of both consumer and capital goods are produced in the economy.
Economic growth enables the economy to have more of both the goods.
Conclusion:

All these central problems of an economy are interrelated and
interdependent. They arise from the fundamental economic problems of
scarcity of means and multiplicity of ends which lead to the problem of choice
or economizing of resources.
Production possibility curve:
What Is the Production Possibility Frontier (PPF)?
In business analysis, the production possibility frontier (PPF) is a curve that illustrates the
possible quantities that can be produced of two products if both depend upon the same finite
resource for their manufacture.
PPF also plays a crucial role in economics. It can be used to demonstrate the point that any
nation's economy reaches its greatest level of efficiency when it produces only what it is best
qualified to produce and trades with other nations for the rest of what it needs.
The PPF is also referred to as the production possibility curve or the transformation curve.
KEY TAKEAWAYS
• In business analysis, the production possibility frontier (PPF) is a curve
illustrating the varying amounts of two products that can be produced
when both depend on the same finite resources.
• The PPF demonstrates that the production of one commodity may
increase only if the production of the other commodity decreases.
• The PPF is a decision-making tool for managers deciding on the optimum
product mix for the company.
Nature of Laws of Economics
In order to understand the importance of laws of economics and their
utility in daily business practices, it is required to comprehend the nature of
these laws.
While studying the law of economics, it is important to note that
all economic laws are based on certain assumptions.
The following points describe the nature of economic laws:
1. Lack of exactness
2. Hypothetical
3. Statement of propensity
Lack of exactness
In comparison to the laws of natural sciences, the law of economics are not
exact. An economist can only state the events that are likely to happen in
the future but cannot be assured of their occurrence.
There are three reasons for the lack of exactness in economic laws.

• Firstly, these laws are concerned with human behaviour which is
dynamic. The uncertainty of human behaviour makes it difficult to predict
the actual course of action for the future.
• Secondly, due to changes in human attitudes, perceptions, and
preferences, factual data is difficult to be collected, which is the base of
economic laws.
• Thirdly, the business environment is so dynamic that any change in it will
simply falsify the economic prediction.
Hypothetical
Law of economics is always based on the fulfilment of specific conditions,
which means these laws are subject to the hypothesis.
For example, the rise in demand for a product is subject to a condition, i.e.
reduction in price and other factors are constant. Moreover,
the supply must not reduce during that period.
Statement of propensity
As discussed, economic laws require certain conditions to be fulfilled to be
true. However, these conditions cannot be exactly predicted.
For example, an increase in demand for a product tends to increase in its
rice. However, the price may not rise as it is dependent on supply too.
Science engineering , tech and economic development:
• Lets start with Economics.
Lets go back in time to 1950’s when radios were all the rage.
Radio was fun and engaging. They were popular. Advertisers
poured money and it was a good business. Then, however,
people wanted more. Imagine watching that sports game
rather than hearing the commentary. This idea seemed big.
• Science
So now people wanted to see the match in addition to
hearing about it. Enter science. The tech behind television is
based on solid principles of physics. How light behaves, how
photons behave when scattered across a medium and so on.
This is where your plain jane research scientists worked

together to come up innovative techniques to harness the
power of physics into something which can be used by
engineers for building the fabled TV.
• Engineering
So now the science guys have established theories and come
out with some cool new technology. The engineers now work
on that to bring it to life. This involves applying the theory of
light and related knowledge to build something practical.
This involves building the CRT tube, adding speakers and so
on.
• Technology
So now the initial TV is built and is working. The next task is
agreeing on a broadcast standard, adding useful features like
maybe picture adjustment, way of tuning channels and so on.
This is where the technology aspect comes in.
• Economics
Once the TV is built..it needs to be manufactured in large
numbers, marketed and actually make it available to end
users for purchase.
This is where economics and market plays a role.
Manufacturers started flooding the markets with TV’s,
advertising about it and so on.
Eventually it became mainstream.
Demand
In our daily life, we often hear the word ‘demand’ for goods or services. In the
business world, the demand of a product determines its value and the profit or
loss of a company. So, today in this article, we will understand ‘what actually is
demand? and ‘why is it so important for a business?’
What is demand?
Demand simply means a consumer’s desire to buy goods and services without
any hesitation and pay the price for it. In simple words, demand is the number of
goods that the customers are ready and willing to buy at several prices during a
given time frame. Preferences and choices are the basics of demand, and can be
described in terms of the cost, benefits, profit, and other variables.
The amount of goods that the customers pick, modestly relies on the cost of the
commodity, the cost of other commodities, the customer’s earnings, and his or

her tastes and proclivity. The amount of a commodity that a customer is ready to
purchase, is able to manage and afford at provided prices of goods, and
customer’s tastes and preferences are known as demand for the commodity.
The demand curve is a graphical depiction of the association between the price
of a commodity or the service and the number demanded for a given time frame.
In a typical depiction, the cost will appear on the left vertical axis. The number
(quantity) demanded on the horizontal axis is known as a demand curve.
Determinants of Demand
There are many determinants of demand, but the top five determinants of
demand are as follows:
Product cost: Demand of the product changes as per the change in the price of
the commodity. People deciding to buy a product remain constant only if all the
factors related to it remain unchanged.
The income of the consumers: When the income increases, the number of
goods demanded also increases. Likewise, if the income decreases, the demand
also decreases.
Costs of related goods and services: For a complimentary product, an increase
in the cost of one commodity will decrease the demand for a complimentary
product. Example: An increase in the rate of bread will decrease the demand for
butter. Similarly, an increase in the rate of one commodity will generate the
demand for a substitute product to increase. Example: Increase in the cost of tea
will raise the demand for coffee and therefore, decrease the demand for tea.
Consumer expectation: High expectation of income or expectation in the
increase in price of a good also leads to an increase in demand. Similarly, low
expectation of income or low pricing of goods will decrease the demand.
Buyers in the market: If the number of buyers for a commodity are more or
less, then there will be a shift in demand.
Types of Demand
Few important different types of demand are as follows:
1. Price demand: It refers to various types of quantities of goods or services
that a customer will buy at a quoted price and given time, considering the
other things remain constant.
2. Income demand: It refers to various types of quantities of goods or
services that a customer will buy at different stages of income,
considering the other things remain constant.

3. Cross demand: This means that the product’s demand does not depend
on its own cost but depends on the cost of the other related
commodities.
4. Direct demand: When goods or services satisfy an individual’s wants
directly, it is known as direct demand.
5. Derived demand or Indirect demand: The goods or services demanded or
needed for manufacturing the goods and satisfying the consumer
indirectly is known as derived demand.
6. Joint demand: To produce a product there are many things that are
related to each other, for example, to produce bread, we need services
like an oven, fuel, flour mill, and more. So, the demand for other
additional things to produce a product is known as joint demand.
7. Composite demand: A composite demand can be described when goods
and services are utilised for more than one cause. Example: Coal
The Law of Demand
The law of demand is interpreted as ‘the quantity demanded of a product comes
down if the price of the product goes up, keeping other factors constant.’ In
other words, if the cost of the product increases, then the aggregate quantity
demanded decreases. This is because the opportunity cost of the customers
increases that leads the customers to go for any other substitute or they may not
purchase it. The law of demand and its exceptions are really inquisitive
concepts.
Consumer proclivity theory assists us in comprehending the combination of two
commodities that a customer will purchase based on the market prices of the
commodities and subject to a customer’s budget restriction. The amount of a
commodity that a customer actually purchases is the interesting part. This is best
elucidated in microeconomics utilising the demand function.
Elasticity of Demand
What is the elasticity of demand?
It is the demand for a commodity that moves in the contrary direction of its
price. However, the influence of the price change is not always constant .
Sometimes, the demand for a commodity changes substantially, even for smaller
price changes. On the other hand, there are some commodities for which the
demand is not impacted much by price changes.
The demands for some commodities are receptive to the change in its price,
while the demands for others are not so receptive to the price changes. The price
elasticity of demand is the quantity of the receptiveness of the demand for a
commodity to change in its price.

The price elasticity of demand for a commodity is defined as the percentage of
change in demand for the commodity divided by the percentage change in its
price. The price elasticity of demand for a good is derived as follows:
Elasticity of demand = Percentage change in demand for the goods ÷
Percentage change in price for the goods
Demand Curve and The Law of Demand
What is Demand Curve?
Demand curve is a curve that is used in microeconomics to determine the
quantity of any particular commodity that people are willing to purchase with
corresponding changes in its price.
It is represented as the price of the commodity on the y-axis and the quantity
demanded on the x-axis in a graph.
What is the Law of Demand?
The law of demand is regarded as one of the most basic concepts that are being
studied in the field of economics. It states that keeping all the other factors
constant (ceteris paribus), the demanded quantity of a good is shown to exhibit
an inverse relationship with the price of the good.
In simple words, with an increase in price, the demand decreases and with a
decrease in price, the demand increases. The law of demand is used in
conjunction with the law of supply to determine an efficient resource allocation
and the optimum quantity and price of goods.
The consumer preference theory helps in understanding the combination of
goods that a consumer might prefer, taking into account the budgetary
constraints and the price of goods in the market.
The best explanation for this is found in microeconomics using the demand
function, where demand functions are derived from the indifference curves.
Q.1 Define demand. Explain any four important factors
that affect the demand for a commodity.
Answer:

(A)
Definition of
demand
● Demand may be defined as the
quantity of a commodity that a consumer is
able and willing to buy, at each possible
price, over a given period of time.
● Essential elements of demand are
quantity, ability, willingness, prices, and
period of time.
(B) The following are the important factors that affect the demand of a
commodity:
(a) Own price of the
given commodity
[Pi20 Car Di20 Car] [Pi20 Car Di20 Car]…Inverse
Relation
Own price is the most important
determinant of demand.
When the own price of a commodity falls,
its demand rises and when its own price
rises, its demand falls.
Thus, we can say that there is an indirect
relation between the price of a commodity
and its quantity demanded.
(b) Price of related
goods
Substitute goods [PMaruti Swift Di20 Car]…Direct
Relation
Complementary goods [PPetrolDi20
Car]…Inverse Relation
Related goods are of two types. They are
substitute and complementary.
(i) Substitute goods
When the prices of the substitute goods
rise, the demand for the given commodity
also rises and vice versa.

For example, if the price of Maruti Swift
increases, the demand for i20 will rise.
(ii)Complementary goods
(Car and Petrol) When the prices of the
complementary goods rise, the demand for
the given commodity falls and vice versa.
For example, if the price of petrol rises, the
demand for cars falls.
(c) income of the
consumer
[IncomeHouseholdDNormal Goods]…Direct relation
[IncomeHouseholdDInferior Goods]…Inverse relation
To check the effect of change in the income
of households over their demand, goods are
divided into two categories. They are as
follows:
(i) Normal goods (Positive relation)
These are the goods whose demand rises
with the rise in income. Example: Basmati
rice
(ii) Inferior goods (Negative relation)
These are the goods whose demand falls
with the rise in income and vice versa.
Example: Low quality rice
(iii) Necessities:
A third category is also there,
necessities, demand for
these generally does not
change with change in
income e.g. life-saving drugs.
(d) Tastes and
preferences of the
consumer
The demand for a commodity is also
affected by tastes and preferences.
It rises if there is a favourable change in the
tastes and preferences of the consumer and
vice versa.

(e) Miscellaneous Future expectations about price and
income also affect the demand for a
commodity in the present.
Suppose, if we expect a rise in price in the
near future, then we will increase demand in
the present even at the same price.
Section-b
Meaning of Production:
Production is an activity of utter importance for any economy. In fact, a nation
with a high level of productive activities spearheads the prosperity charts. This
is because raw goods, surely are valuable, but production done upon these raw
goods adds up to their value or their want-satisfying power.
We are aware of the fact that utility is the want-satisfying power of any
commodity or service. Evidently, the countries that have a high level of
production accompanied by the production of a wide variety of goods, are
termed as the golden economies.
In light of the above-mentioned facts, we can conclude that production is the
process of working upon the resources of nature and pushing or creating their
utilities in order to satisfy the wants of consumers. However, the term
production in Economics is more than what meets the eyes.
Production is not only concerned with the tangible aspect. Rather production
also includes any service that can satisfy the wants of people. Hence now you
know why the service of transportation is a process of production too. Notice
how this service is intangible.
It is important to note that production cannot account for the creation of the
seed, but it accounts for the transformation of the seed into a tree, the sale of the
fruits grown on that tree and so on. In other words, production is not the
creation of matter, which is also out of the realms of human powers.
Processes in Production
We now know the meaning of production, that production creates or adds
utility. There are various processes through which we can achieve the aim of

utility creation or addition to ultimately satisfy human wants. These processes
are as follows:
Utility of Form
The manufacturing processes that take physical inputs and produce physical
outputs, eventually increasing the utility of the resource being manufactures, are
integral branches in the production tree. These processes are the most obvious
forms of production. They change the form of the goods under concern, in
order to satisfy a greater human want.
For example, changing a log of wood into a table or chair is a manufacturing
process. Further, such processes add to the utility of form of the raw materials.
Personal Utility
Unlike the manufacturing processes which are tangible, there are various
intangible services that contribute towards the utility of the goods. For instance,
apples have to be sold by merchants to consumers. The services of labor are
also a part of this category. Such services are intangible but are as important as
other processes of production. This imparts personal utility to the materials.
Utility of Place
Another process involves changing the place of the resources, to a place where
they experience a greater demand and use.
• This includes the extraction of natural resources from earth e.g. mining
of ores, gold, coal, metal ores, etc. These are further transported to
markets where they can be sold.
• Transportation service from a place where the resource gives little
satisfaction to a place where it provides a lot of satisfaction also adds
up to the utility. For example, once extracted, the metal ore needs to
be taken to an industrial site where it can be further processed. This
concept is also known as the utility of place. This includes all the
additional utility conferred through the efforts of transportation
services or transport agents for the movement and marketing of
goods.
Utility of Time
Lastly, storage and manipulating availability drastically change the utility of
products. For example, seasonal fruits are canned and various preservation

techniques are used for their storage so that they can be sold for higher prices
during off-seasons.
Let’s take another example of umbrellas. The demand for umbrellas touches
the sky during monsoons. In such a case, production of umbrellas takes place
generally during the off-season and stored until the monsoon. At the advent of
monsoon, the producers release their stocks of umbrellas to meet the increasing
the demand. In this way, we add the utility of time through the process of
production.
Let’s discuss an example where the addition of all the above-mentioned utilities
takes place through production. First, the raw wool is sent to a mill for spinning
and weaving (utility of form). Next, transportation of finished wool to potential
market takes place (utility of place). Further, the demand for woolen clothes
increases in winter, hence producers hold a majority of their stocks until winters
(utility of time). Lastly personal services of transport agents, merchants,
labours, etc. form an integral part of the whole process of production (personal
utility).
Factors of Production:
Land as a Factor of Production
A man with little or no knowledge of economics would think of the
significance of land as an area required for production. On the contrary, the
definition of land in the economics, of course, is an area, but also includes all
the free gifts of nature like water, air, natural resources etc. which affect
production.
To point out, a factor of production can be a combination of work done by
human efforts and natural occurrences. In that case, there are some
characteristics that ease out this confusion by clarifying the factor of
production-land.

Free Gift of Nature
Every factor of production which comes under the umbrella of land should have
no supply price. To put it differently, land can be used for production without
paying any money to the ultimate owner i.e. the mother earth. Further, it
requires no human effort.
Fixed Supply
Land is a strictly fixed factor of production. Obviously, the quantity of land in
existence will always remain the same and no human power can alter that. This
means that no amount of change in demand can change the supply of land. To
point out, this characteristic is evidence that the supply of land is perfectly
inelastic.
However, any free gift of nature is abundant, when seen through the lens of a
single firm. Hence we can conclude that the supply of land is perfectly inelastic
from the perspective of an economy whereas it is relatively elastic from the
perspective of a single firm.
Permanent and has Indestructible Powers
Most of the features related to land are out of the realms of human power. We
can only degrade or upgrade the characteristics of land up to an extent. The
quantity of land and specifically the land itself is indestructible.
Immobile
Of course, land is a static factor. One cannot shift the natural resources from
their places of origin. Now some would argue that a factor categorized as land,

say water, can be taken to another place. However, you should appreciate the
fact that the whole reservoir of water cannot be shifted to another place at will.
Further, the combination of natural factors or characteristics of a given place is
generally unique.
Has Multiple Uses
We can use land in a variety of ways, for various purposes. Hence, land has
multiple uses. However, its suitability for all uses is definitely not the same. For
instance, we can use a piece of infertile land to set up a factory but not for
cultivation and agriculture.
Heterogeneous
Obviously, no two types of land can be the same. There are a plethora of
characteristics which define a type of land and two instances of land are bound
to differ on at least one of these characteristics. For example, two patches of
land can differ in fertility, dimensions, composition and a lot of other
characteristics.
Factors of Production – Labour
Labour actually means any type of physical or mental exertion. In economic
terms, labour is the efforts exerted to produce any goods or services. It includes
all types of human efforts – physical exertion, mental exercise, use of intellect,
etc. done in exchange for an economic reward. Let us see the features of labour
as a factor of production.
Characteristics of Labour as a Factor of Production
1] Perishable in Nature
Labour is perishable in nature. This simply means that it has to storage
capacity, i.e. labour cannot be stored. If a worker does not turn up to work for
one shift his labour of that shift is lost completely. It cannot be stored and
utilized the next day. That labour is lost permanently. A laborer cannot store his
labour to use at another time. So we say labour as a factor of production is
highly perishable.

2] Labour is Inseparable from the Labourer
This means the physical presence of the laborer is compulsory. To sell his
services the laborer has to be physically present at the place of production of
goods or services. We cannot separate him and his labour power. So we cannot
expect a welder to do his work from home, he has to present at the site of the
work.
3] Human Effort
Labour is a unique factor of production in comparison with others. It is directly
related to human effort, unlike the others. So there are certain special factors we
must take into consideration when it comes to labour. Fair treatment of
workers, rest times, suitable work environment, idle time, etc are just some
such factors.
4] Labour is Heterogeneous
We cannot expect labour to be uniform. Every laborer is unique and so his
labour power will also differ from the others. The quality and the efficiency of
the labour will depend on the skills, work environment, incentives and other
inherent qualities of the laborer.
5] Labour has Poor Bargaining Power
Labour as a factor of production has a very week bargaining power with the
buyer of the services. It cannot be stored, isn’t very mobile and has no standard
or reserve price. So generally laborers are forced to work for
whatever wages the employer offers. In comparison to the employer, the
laborers have very little bargaining power.
There is also the problem that laborers do not have any other reserves to fall
back on. They are usually poor and ignorant. And this labour work is their only
source of income. So they accept whatever wages the employer offers.
6] Not Easily Mobile
Labour as a factor of production is mobile, i.e. the laborers can relocate to the
site of work. But there are many barriers to the movement of labour from one
place to another. So we can say labour is not as mobile as some other factors of
production like Capital.

7] Supply of Labour is relatively Inelastic
At any given point in time, the supply of labour in the market is inelastic. It
cannot be increased instantly to keep up with the demand. So say there is a
shortage of skilled labour in India, skilled laborers cannot be generated in a day,
a week or even a year.
We may be able to import some labour for a short period. But generally, the
supply of labour is very inelastic, since we cannot increase or decrease it
instantaneously.
Factors of Production – Capital
For any business to start and function the first requirement is money. This is the
capital of the firm. It forms the basis of the company and all other factors of
production are bought with the capital. Capital consists of all types of wealth,
even the free gifts of nature. Let us learn more about capital and capital
formation.
Capital as a Factor of Production
We can define capital as the productive part of a firm’s wealth. Wealth is the
sum of all money, goods, human values, etc that can be useful in the production
of further wealth. But capital is the part of this wealth that is currently in
productive use. Resources lying idle are wealth but not capital.
So capital is known as the man-made means of production. Hence capital will
include every man-made goods that are used in the production process. This
differentiates both land and labour from capital since both of these are not man-
made. So machinery, tools, plant, instruments, factories, transport vehicles, etc
are all forms of capital itself.
Features of Capital
• Capital is a passive factor of production. It needs labour to be
productive.
• Capital is variable in nature. It increases and decreases according to
the needs of the firm

• Among all the other factors of production, capital is the most mobile.
Transportation of capital is an easy activity
• Also capital is destructible in nature. It’s not permanent like land. For
example, a machine will wear and tear and may even completely break
down with time.
Capital Formation
Capital formation essentially means investment. It involves an increase in the
production of capital goods in a country. These goods include machines,
factories, power supply units, railways, roadways, etc. The need for capital
formation arises not only out of replacement or renovation but also to increase
the production capacity of an economy. Let us take a look at the stages of
capital formation.
1] Increase in Real Savings
With an increase in income, there is an increase in savings. So higher income
generally means higher savings. This is true for individuals as well as an
economy as a whole. A richer country has more capacity to save and increase
its wealth than a relatively poorer country.
But only the ability to save is not enough. There should be a willingness to
save. A person with one eye on the future will save more and create wealth. The
government also encourages savings for its citizens. They provide tax benefits
and exemptions on saving schemes. For an economy both individual savings
and government savings are important.
2] Mobilization of Savings
Only saving does not lead to capital formation. These savings have to be
mobilized. The banks, financial institution, etc collect these savings and offer
them to prospective investors. So such institutions and financial products
should be available to the public. And they should also be attractive in terms of
returns. The state will play an important role in the mobilization of savings as
well.

3] Investment
The final step of capital formation. Here the real savings get converted to actual
investment. The entrepreneurs will properly utilize these savings to generate
more income and more wealth and the cycle will continue.
Factors of Production – Entrepreneur:
There are four main factors of production. Land, Labour, and Capital are the
main factors of production. The entrepreneur is the one that combines these
factors in the correct proportion and mobilizes them. Let us learn more about
entrepreneurs and their main functions.
Factors of Production – Entrepreneurs
The entrepreneur is the one that initiates the process of production by
mobilizing the other factors of production. He organizes, manages and controls
the affairs of the firm. He is the risk bearer and in consideration of this the
profit maker as well. Simply put the entrepreneur is the owner of the business.
However, these are the days of specialization. So we often see a separation
between ownership and management. So we now have a different set of
functions for the managers and the entrepreneurs.
The managers take care of the routine day to day decisions. The entrepreneurs
focus on the risk bearing and initiating production. Let us take a look at some
functions of the entrepreneur.
1] Initiating the Business
This is the first function of the entrepreneur, to actually start a business. Firstly
the entrepreneur spots business opportunities in the economy he can exploit.
Then he develops the project ideas and decides on the scale of the business.
Finally, he must obtain the different factors of productions to get the ball
rolling.
The entrepreneur has to build up his business dynamically. He must coordinate
the factors of production and utilize them in the right proportions. The aim is to
generate higher productivity from these factors. So the entrepreneur must get
the greatest yield for the lowest cost from these factors of production.

2] Risk Bearing
This is perhaps the most important function of entrepreneurs. The entrepreneurs
bear the risks of failure in exchange for the profits of the company. So in
dynamic economic model things can change very fast. So the business plans of
the entrepreneur should be able to adapt to the changes.
The consumer taste may change, there can be new entrants in the market, taxes
may increase, etc. These will all affect the demand and supply of the product.
And in turn, the entrepreneur may face some financial losses. Entrepreneurs
have to bear these financial risks.
Then there are technological risks as well. These days we make technological
advancements every day. So there is a risk that the product may become
obsolete. Or more innovative means of production may be developed. There are
other risks such as theft, accidents, etc.
In exchange for all these risks, the entrepreneurs enjoy the profits earned by the
firm. Profit is their reward for bearing the risks. Unlike some of the other
management functions, risk bearing cannot be delegated to the manager. The
owner/entrepreneurs have to bear all the risk.
3] Innovation
One of the other important functions of entrepreneurs is to continuously
innovate. This innovation can be in the field of new products, new production
methods/technology, new business models, exciting and new promotion tactics,
exploring new markets, etc. This will help entrepreneurs with the economic
growth of the firm.
However, any new innovation or technology comes with its own share of new
risks as well. It will be the job of the entrepreneur to manage such risks in
exchange for the scope for higher returns and higher profits. Ultimately this
innovative spirit of the entrepreneur will lead to advancements in the firm and
even the economy as a whole. The most successful entrepreneurs are all great
innovators.
Law of variable proportions:

Definitions:
“As the proportion of the factor in a combination of factors is increased after a
point, first the marginal and then the average product of that factor will
diminish.” Benham
“An increase in some inputs relative to other fixed inputs will in a given state
of technology cause output to increase, but after a point the extra output
resulting from the same additions of extra inputs will become less and less.”
Samuelson
“The law of variable proportion states that if the inputs of one resource is
increased by equal increment per unit of time while the inputs of other
resources are held constant, total output will increase, but beyond some point
the resulting output increases will become smaller and smaller.” Leftwitch
Assumptions:
Law of variable proportions is based on following assumptions:
(i) Constant Technology:
The state of technology is assumed to be given and constant. If there is an
improvement in technology the production function will move upward.
(ii) Factor Proportions are Variable:
The law assumes that factor proportions are variable. If factors of production
are to be combined in a fixed proportion, the law has no validity.
(iii) Homogeneous Factor Units:
The units of variable factor are homogeneous. Each unit is identical in quality
and amount with every other unit.
(iv) Short-Run:
The law operates in the short-run when it is not possible to vary all factor
inputs.
Explanation of the Law:
In order to understand the law of variable proportions we take the example of
agriculture. Suppose land and labour are the only two factors of production.
By keeping land as a fixed factor, the production of variable factor
i.e., labour can be shown with the help of the following table:

From the table 1 it is clear that there are three stages of the law of variable
proportion. In the first stage average production increases as there are more
and more doses of labour and capital employed with fixed factors (land). We
see that total product, average product, and marginal product increases but
average product and marginal product increases up to 40 units. Later on, both
start decreasing because proportion of workers to land was sufficient and land
is not properly used. This is the end of the first stage.
The second stage starts from where the first stage ends or where AP=MP. In
this stage, average product and marginal product start falling. We should note
that marginal product falls at a faster rate than the average product. Here,
total product increases at a diminishing rate. It is also maximum at 70 units of
labour where marginal product becomes zero while average product is never
zero or negative.
The third stage begins where second stage ends. This starts from 8th unit.
Here, marginal product is negative and total product falls but average product
is still positive. At this stage, any additional dose leads to positive nuisance
because additional dose leads to negative marginal product.
Graphic Presentation:
In fig. 1, on OX axis, we have measured number of labourers while quantity of
product is shown on OY axis. TP is total product curve. Up to point ‘E’, total
product is increasing at increasing rate. Between points E and G it is
increasing at the decreasing rate. Here marginal product has started falling.
At point ‘G’ i.e., when 7 units of labourers are employed, total product is
maximum while, marginal product is zero. Thereafter, it begins to diminish
corresponding to negative marginal product. In the lower part of the figure
MP is marginal product curve.

Up to point ‘H’ marginal product increases. At point ‘H’, i.e., when 3 units of
labourers are employed, it is maximum. After that, marginal product begins to
decrease. Before point ‘I’ marginal product becomes zero at point C and it
turns negative. AP curve represents average product. Before point ‘I’, average
product is less than marginal product. At point ‘I’ average product is
maximum. Up to point T, average product increases but after that it starts to
diminish.
Three Stages of the Law:
1. First Stage:
First stage starts from point ‘O’ and ends up to point F. At point F average
product is maximum and is equal to marginal product. In this stage, total
product increases initially at increasing rate up to point E. between ‘E’ and ‘F’
it increases at diminishing rate. Similarly marginal product also increases
initially and reaches its maximum at point ‘H’. Later on, it begins to diminish
and becomes equal to average product at point T. In this stage, marginal
product exceeds average product (MP > AP).
2. Second Stage:
It begins from the point F. In this stage, total product increases at diminishing
rate and is at its maximum at point ‘G’ correspondingly marginal product
diminishes rapidly and becomes ‘zero’ at point ‘C’. Average product is
maximum at point ‘I’ and thereafter it begins to decrease. In this stage,
marginal product is less than average product (MP < AP).

3. Third Stage:
This stage begins beyond point ‘G’. Here total product starts diminishing.
Average product also declines. Marginal product turns negative. Law of
diminishing returns firmly manifests itself. In this stage, no firm will produce
anything. This happens because marginal product of the labour becomes
negative. The employer will suffer losses by employing more units of
labourers. However, of the three stages, a firm will like to produce up to any
given point in the second stage only.
In Which Stage Rational Decision is Possible:
To make the things simple, let us suppose that, a is variable factor and b is the
fixed factor. And a1, a2 , a3….are units of a and b1 b2b3…… are unit of b.
Stage I is characterized by increasing AP, so that the total product must also
be increasing. This means that the efficiency of the variable factor of
production is increasing i.e., output per unit of a is increasing. The efficiency
of b, the fixed factor, is also increasing, since the total product with b1 is
increasing.
The stage II is characterized by decreasing AP and a decreasing MP, but with
MP not negative. Thus, the efficiency of the variable factor is falling, while the
efficiency of b, the fixed factor, is increasing, since the TP with b1 continues to
increase.
Finally, stage III is characterized by falling AP and MP, and further by
negative MP. Thus, the efficiency of both the fixed and variable factor is
decreasing.
Rational Decision:
Stage II becomes the relevant and important stage of production. Production
will not take place in either of the other two stages. It means production will
not take place in stage III and stage I. Thus, a rational producer will operate in
stage II.
Suppose b were a free resource; i.e., it commanded no price. An entrepreneur
would want to achieve the greatest efficiency possible from the factor for

which he is paying, i.e., from factor a. Thus, he would want to produce where
AP is maximum or at the boundary between stage I and II.
If on the other hand, a were the free resource, then he would want to employ b
to its most efficient point; this is the boundary between stage II and III.
Obviously, if both resources commanded a price, he would produce
somewhere in stage II. At what place in this stage production takes place
would depend upon the relative prices of a and b.
Condition or Causes of Applicability:
There are many causes which are responsible for the application of the law of
variable proportions.
They are as follows:
1. Under Utilization of Fixed Factor:
In initial stage of production, fixed factors of production like land or machine,
is under-utilized. More units of variable factor, like labour, are needed for its
proper utilization. As a result of employment of additional units of variable
factors there is proper utilization of fixed factor. In short, increasing returns
to a factor begins to manifest itself in the first stage.
2. Fixed Factors of Production.
The foremost cause of the operation of this law is that some of the factors of
production are fixed during the short period. When the fixed factor is used
with variable factor, then its ratio compared to variable factor falls.
Production is the result of the co-operation of all factors. When an additional
unit of a variable factor has to produce with the help of relatively fixed factor,
then the marginal return of variable factor begins to decline.
3. Optimum Production:
After making the optimum use of a fixed factor, then the marginal return of
such variable factor begins to diminish. The simple reason is that after the
optimum use, the ratio of fixed and variable factors become defective. Let us
suppose a machine is a fixed factor of production. It is put to optimum use
when 4 labourers are employed on it. If 5 labourers are put on it, then total
production increases very little and the marginal product diminishes.
4. Imperfect Substitutes:
Mrs. Joan Robinson has put the argument that imperfect substitution of
factors is mainly responsible for the operation of the law of diminishing
returns. One factor cannot be used in place of the other factor. After optimum
use of fixed factors, variable factors are increased and the amount of fixed
factor could be increased by its substitutes.

Such a substitution would increase the production in the same proportion as
earlier. But in real practice factors are imperfect substitutes. However, after
the optimum use of a fixed factor, it cannot be substituted by another factor.
Applicability of the Law of Variable Proportions:
The law of variable proportions is universal as it applies to all fields of
production. This law applies to any field of production where some factors are
fixed and others are variable. That is why it is called the law of universal
application.
The main cause of application of this law is the fixity of any one factor. Land,
mines, fisheries, and house building etc. are not the only examples of fixed
factors. Machines, raw materials may also become fixed in the short period.
Therefore, this law holds good in all activities of production etc. agriculture,
mining, manufacturing industries.
1. Application to Agriculture:
With a view of raising agricultural production, labour and capital can be
increased to any extent but not the land, being fixed factor. Thus when more
and more units of variable factors like labour and capital are applied to a fixed
factor then their marginal product starts to diminish and this law becomes
operative.
2. Application to Industries:
In order to increase production of manufactured goods, factors of production
has to be increased. It can be increased as desired for a long period, being
variable factors. Thus, law of increasing returns operates in industries for a
long period. But, this situation arises when additional units of labour, capital
and enterprise are of inferior quality or are available at higher cost.
As a result, after a point, marginal product increases less proportionately than
increase in the units of labour and capital. In this way, the law is equally valid
in industries.
Postponement of the Law:
The postponement of the law of variable proportions is possible
under following conditions:
(i) Improvement in Technique of Production:
The operation of the law can be postponed in case variable factors techniques
of production are improved.
(ii) Perfect Substitute:
The law of variable proportion can also be postponed in case factors of
production are made perfect substitutes i.e., when one factor can be
substituted for the other.

What Is Returns to Scale?
Definition:
“The term returns to scale refers to the changes in output as all factors change
by the same proportion.” Koutsoyiannis
“Returns to scale relates to the behaviour of total output as all inputs are
varied and is a long run concept”. Leibhafsky
Returns to scale are of the following three types:
1. Increasing Returns to scale.
2. Constant Returns to Scale
3. Diminishing Returns to Scale
Explanation:
In the long run, output can be increased by increasing all factors in the same
proportion. Generally, laws of returns to scale refer to an increase in output
due to increase in all factors in the same proportion. Such an increase is called
returns to scale.
Suppose, initially production function is as follows:
P = f (L, K)
Now, if both the factors of production i.e., labour and capital are increased in
same proportion i.e., x, product function will be rewritten as.

The above stated table explains the following three stages of
returns to scale:
1. Increasing Returns to Scale:
Increasing returns to scale or diminishing cost refers to a situation when all
factors of production are increased, output increases at a higher rate. It means
if all inputs are doubled, output will also increase at the faster rate than
double. Hence, it is said to be increasing returns to scale. This increase is due
to many reasons like division external economies of scale. Increasing returns
to scale can be illustrated with the help of a diagram 8.
In figure 8, OX axis represents increase in labour and capital while OY axis
shows increase in output. When labour and capital increases from Q to Q1,
output also increases from P to P1 which is higher than the factors of
production i.e. labour and capital.

2. Diminishing Returns to Scale:
Diminishing returns or increasing costs refer to that production situation,
where if all the factors of production are increased in a given proportion,
output increases in a smaller proportion. It means, if inputs are doubled,
output will be less than doubled. If 20 percent increase in labour and capital is
followed by 10 percent increase in output, then it is an instance of diminishing
returns to scale.
The main cause of the operation of diminishing returns to scale is that
internal and external economies are less than internal and external
diseconomies. It is clear from diagram 9.
In this diagram 9, diminishing returns to scale has been shown. On OX axis,
labour and capital are given while on OY axis, output. When factors of
production increase from Q to Q1 (more quantity) but as a result increase in
output, i.e. P to P1 is less. We see that increase in factors of production is more
and increase in production is comparatively less, thus diminishing returns to
scale apply.
3. Constant Returns to Scale:
Constant returns to scale or constant cost refers to the production situation in
which output increases exactly in the same proportion in which factors of
production are increased. In simple terms, if factors of production are
doubled output will also be doubled.
In this case internal and external economies are exactly equal to internal and
external diseconomies. This situation arises when after reaching a certain

level of production, economies of scale are balanced by diseconomies of scale.
This is known as homogeneous production function. Cobb-Douglas linear
homogenous production function is a good example of this kind. This is
shown in diagram 10. In figure 10, we see that increase in factors of
production i.e. labour and capital are equal to the proportion of output
increase. Therefore, the result is constant returns to scale.
What Are Economies of Scale?
Economies of scale are cost advantages reaped by companies when production becomes
efficient. Companies can achieve economies of scale by increasing production and lowering
costs. This happens because costs are spread over a larger number of goods. Costs can be
both fixed and variable.
KEY TAKEAWAYS
• Economies of scale are cost advantages companies experience when production
becomes efficient, as costs can be spread over a larger amount of goods.
• A business's size is related to whether it can achieve an economy of scale—larger
companies will have more cost savings and higher production levels.
• Economies of scale can be both internal and external. Internal economies are
caused by factors within a single company while external factors affect the entire
industry.

Understanding Economies of Scale
The size of the business generally matters when it comes to economies of scale. The larger the
business, the more the cost savings. Economies of scale can be both internal and external.
Internal economies of scale are based on management decisions, while external ones have to
do with outside factors.
Internal functions include accounting, information technology, and marketing. The first two
reasons are also considered operational efficiencies and synergies. The second two reasons are
cited as benefits of mergers and acquisitions.
Economies of scale are an important concept for any business in any industry and represent the
cost-savings and competitive advantages larger businesses have over smaller ones.
Most consumers don't understand why a smaller business charges more for a similar product
sold by a larger company. That's because the cost per unit depends on how much the company
produces. Larger companies can produce more by spreading the cost of production over a
larger amount of goods. An industry may also be able to dictate the cost of a product if several
different companies are producing similar goods within that industry.
There are several reasons why economies of scale give rise to lower per-unit costs. First,
specialization of labor and more integrated technology boost production volumes. Second, lower
per-unit costs can come from bulk orders from suppliers, larger advertising buys, or lower costs
of capital. Third, spreading internal function costs across more units produced and sold helps to
reduce costs.
A company can create a diseconomy of scale when it becomes too large and chases an
economy of scale.
Internal vs. External Economies of Scale
As mentioned above, there are two different types of economies of scale. Internal economies
are borne from within the company. External ones are based on external factors.
Internal economies of scale happen when a company cuts costs internally, so they're unique to
that particular firm. This may be the result of the sheer size of a company or because of
decisions from the firm's management. Larger companies may be able to achieve internal
economies of scale—lowering their costs and raising their production levels—because they can
buy resources in bulk, have a patent or special technology, or because they can access more
capital.
External economies of scale, on the other hand, are achieved because of external factors, or
factors that affect an entire industry. That means no one company controls costs on its own.
These occur when there is a highly skilled labor pool, subsidies and/or tax reductions, and
partnerships and joint ventures—anything that can cut down on costs to many companies in a
specific industry.
Limits to Economies of Scale
Management techniques and technology have been focusing on limits to economies of scale for
decades.
Set-up costs are lower due to more flexible technology. Equipment is priced more closely to
match production capacity, enabling smaller producers such as steel mini-mills and craft
brewers to compete more easily.

Outsourcing functional services make costs more similar across businesses of various sizes.
These functional services include accounting, human resources, marketing, treasury, legal, and
information technology.
Micro-manufacturing, hyper-local manufacturing, and additive manufacturing (3D printing) can
lower both set-up and production costs. Global trade and logistics have contributed to lower
costs, regardless of the size of an individual plant.
In aggregate, the average cost of trade-able goods has been falling in industrial countries since
about 1995.
Examples of Economies of Scale
In a hospital, it is still a 20-minute visit with a doctor, but all the business overhead costs of the
hospital system are spread across more doctor visits and the person assisting the doctor is no
longer a degreed nurse, but a technician or nursing aide.
Job shops produce products in groups such as shirts with your company logo. A significant
element of the cost is the setup. In job shops, larger production runs lower unit costs because
the set-up costs of designing the logo and creating the silk-screen pattern are spread across
more shirts. In an assembly factory, per-unit costs are reduced by more seamless technology
with robots.
A restaurant kitchen is often used to illustrate how economies of scale are limited: more cooks in
a small space get into each other's way. In economics charts, this has been illustrated with some
flavor of a U-shaped curve, in which the average cost per unit falls and then rises. Costs rising
as production volume grows is termed "dis-economies of scale."
What are economies of scale?
Economies of scale are the advantages that can sometimes occur as a result of
increasing the size of a business. For example, a business might enjoy an economy of
scale concerning its bulk purchasing. By buying a large number of products at once, it
could negotiate a lower price per unit than its competitors.
What causes economies of scale?
Generally speaking, economies of scale can be achieved in two ways. First, a company
can realize internal economies of scale by reorganizing the way their resources—such as
equipment and personnel—are distributed and used within the company. Second, a
company can realize external economies of scale by growing in size relative to their
competitors using that increased scale to engage in competitive practices such as
negotiating discounts for bulk purchases.
Why are economies of scale important?
Economies of scale are important because they can help provide businesses with a
competitive advantage in their industry. Companies will therefore try to realize
economies of scale wherever possible, just as investors will try to identity economies of
scale when selecting investments. One particularly famous example of an economy of
scale is known as the network effect.
What Are Diseconomies of Scale?
Diseconomies of scale happen when a company or business grows so large that the costs per
unit increase. It takes place when economies of scale no longer function for a firm. With this

principle, rather than experiencing continued decreasing costs and increasing output, a firm
sees an increase in costs when output is increased.
KEY TAKEAWAYS
• Diseconomies of scale occur when the expansion of output comes with increasing
average unit costs.
• Diseconomies of scale can involve factors internal to an operation or external
conditions beyond a firm's control.
• Diseconomies of scale may result from technical issues in a production process,
organizational management issues, or resource constraints on productive inputs.
Understanding Diseconomies of Scale
The diagram below illustrates a diseconomy of scale. At point Q*, this firm is producing at the
point of lowest average unit cost. If the firm produces more or less output, then the average cost
per unit will be higher. To the left of Q*, the firm can reap the benefit of economies of scale to
decrease average costs by producing more. To the right of Q*, the firm experiences
diseconomies of scale and an increasing average unit cost.
Special Considerations
Diseconomies of scale specifically come about due to several reasons, but all can be broadly
categorized as internal or external. Internal diseconomies of scale can arise from technical
issues of production or organizational issues within the structure of a firm or industry.
External diseconomies of scale can arise due to constraints imposed by the environment within
which a firm or industry operates. Essentially, diseconomies of scale are the result of the
growing pains of a company after it's already realized the cost-reducing benefits of economies of
scale.
The first is a situation of overcrowding, where employees and machines get in each other's way,
lowering operational efficiencies. The second situation arises when there is a higher level of
operational waste, due to a lack of proper coordination. The third reason for diseconomies of
scale happens when there is a mismatch in the optimum level of outputs within different
operations.
Types of Diseconomies of Scale
Internal diseconomies of scale involve either technical constraints on the production process that
the firm uses or organizational issues that increase costs or waste resources without any
change to the physical production process.
Technical Diseconomies of Scale
Technical diseconomies of scale involve physical limits on handling and combining inputs and
goods in process. These can include overcrowding and mismatches between the feasible scale
or speed of different inputs and processes.
Diseconomies of scale can occur for a variety of reasons, but the cause often comes
from the difficulty of managing an increasingly large workforce.
An overcrowding effect within an organization is often the leading cause of diseconomies of
scale. This happens when a company grows too quickly, thinking that it can achieve economies
of scale in perpetuity. If, for example, a company can reduce the per-unit cost of its product each
time it adds a machine to its warehouse, it might think that maxing out the number of machines
is a great way to reduce costs.

However, if it takes one person to operate a machine, and 50 machines are added to the
warehouse, there is a good chance that these 50 additional employees will get in each other's
way and make it harder to produce the same level of output per hour. This increases costs and
decreases output.
Sometimes, diseconomies of scale happen within an organization when a company's plant
cannot produce the same quantity of output as another related plant. For example, if a product is
made up of two components, gadget A and gadget B, diseconomies of scale might occur if
gadget B is produced at a slower rate than gadget A. This forces the company to slow
the production rate of gadget A, increasing its per-unit cost.
Organizational Diseconomies of Scale
Organizational diseconomies of scale can happen for many reasons, but overall, they arise
because of the difficulties of managing a larger workforce. Several problems can be identified
with diseconomies of scale.
First, communication becomes less effective. As a business expands, communication between
different departments becomes more difficult. Employees may not have explicit instructions or
expectations from management. In some instances, written communication becomes more
prevalent over face-to-face meetings, which can lead to less feedback.
Another drawback to diseconomies of scale is motivation. Larger businesses can isolate
employees and make them feel less appreciated, which can result in a drop in productivity.
External Diseconomies of Scale
External diseconomies of scale can result from constraints of economic resources or other
constraints imposed on a firm or industry by the external environment within which it operates.
Typically, these include capacity constraints on common resources and public goods or
increasing input costs due to price inelasticity of supply for inputs.
External capacity constraints can arise when a common pool resource or local public good
cannot sustain the demands placed on it by increased production. Congestion on public
highways and other transportation needed to ship a firm's products is an example of this type of
diseconomy of scale.
As output increases, the logistical costs of transporting goods to distant markets can increase
enough to offset any economies of scale. A similar example is the depletion of a critical natural
resource below its ability to reproduce itself in a tragedy of the commons scenario. As the
resource becomes ever more scarce and ultimately runs out, the cost to obtain it increases
dramatically.
Price inelasticity of supply for key inputs traded on a market is a related cause of diseconomies
of scale. In this case, if a firm attempts to increase output, it will need to purchase more inputs,
but price inelastic inputs will mean rapidly increasing input costs out of proportion to the increase
in the amount of output realized.
Different kinds of costs:
Fixed Costs
Fixed costs do not vary with the number of goods or services a company produces over the
short term. For example, suppose a company leases a machine for production for two years.
The company has to pay $2,000 per month to cover the cost of the lease, no matter how many
products that machine is used to make. The lease payment is considered a fixed cost as it
remains unchanged.

Variable Costs
Variable costs fluctuate as the level of production output changes, contrary to a fixed cost. This
type of cost varies depending on the number of products a company produces. A variable cost
increases as the production volume increases, and it falls as the production volume decreases.
For example, a toy manufacturer must package its toys before shipping products out to stores.
This is considered a type of variable cost because, as the manufacturer produces more toys, its
packaging costs increase, however, if the toy manufacturer's production level is decreasing, the
variable cost associated with the packaging decreases.
1. Money Costs:
Money cost is also known as the nominal cost. It is nothing but the expenses
incurred by a firm to produce a commodity. For instance, the cost of
producing 200 chairs is Rs. 10000, and then it will be called the money cost of
producing 200 chairs.
Therefore, money costs include the following expenses:
(i) Depreciation and obsolescence charges.
(ii) Power fuel charges.
(iii) Wages and salaries.
(iv) Cost of machinery, raw material etc.
(v) Expenses on advertising and publicity,
(vi) Interest on capital.
(vii) Expenses on electricity.
(viii) Insurance charges.
(ix) Transport costs.
(x) Packing charges.
(xi) All types of taxes viz; property tax, license fees, excise duty.
(xii) Rent on land.
Therefore, money costs relate to money outlays by a firm on factors of
production which enable the firm to produce and sell a product. Every
producer is interested only in nominal costs. Thus, in the words of Prof.
Hanson, “The money cost of producing a certain output of a commodity is the
sum of all the payments to the factors of production engaged in the
production of that commodity.”
Moreover, total costs of a firm include both:

(i) Explicit as well as
(ii) Implicit costs.
(a) Explicit Costs:
Explicit costs refer to all those expenses made by a firm to buy goods directly.
They include, payments for raw material, taxes and depreciation charges,
transportation, power, high fuel, advertising and so on.
According to Leftwitch, “Explicit costs are those cash payments which firms
make to outsiders for their services and goods.” He has given stress on the
word explicit and it may be called the approach used by the accountant of the
firm. The payments are explicit-clear-cut, paid to agents (owners) of factors of
production. A contract fixes the rate at which the payments are to be made.
The examples are clear to see. These are wages to workers, money paid for
raw materials and semi-finished goods, various fixed costs etc. The producer
takes money out of his pocket and pays to others. These are payments to
attract resources from other uses to the use made by a particular producer.
They are also known as Accounting Costs or Historical Costs.
(b) Implicit Costs:
Implicit costs are the imputed value of the entrepreneur’s own resources and
Services. In fact, these costs refer to the implied or unnoticed costs. They
include the interest on his own capital, rent on his land, wages of his own
labour etc. Moreover, these costs go to the entrepreneur himself and are not
recorded in practice. In the words of Leftwitch, “Implicit costs are the costs of
self-owned, self employed resources.”
In short we can say that:
Economic costs = Explicit costs – Implicit costs
There are some resources which are “self-owned” and are self- employed”; the
cost is in the shape of income given up rather than payment made. The
income forgone is income which could have been earned by allowing the
resources to be used by somebody else and the ‘cost’ is at the rate at which
income could be earned in the next best use.
Suppose a producer uses his own money in his own business. He does not pay
any interest to himself, but he could have earned some money if he had given
the money as loan to someone else. Thus for personal capital, self-employed
rate of interest would be imputed at the rate at which it could earn interest
somewhere else. To make the approach still more realistic, the modern
economists prefer to add normal profit to implicit and explicit costs of
production.

2. Real Costs:
Another concept of costs is the real costs. It is a philosophical concept which
refers to all those efforts and sacrifices undergone by various members of the
society to produce a commodity. Like monetary costs, real costs do not tell us
anything what lies behind these costs. Prof. Marshall has called these costs as
the “Social Costs of Production.”
According to Marshall, “Real costs are the exertion of all the different kinds of
labour that are directly or indirectly involved in making it together with the
abstinence rather than 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.”
In this way, real cost means the trouble, sacrifice of factors in producing a
commodity. Though, this concept gained momentum for sometime it has been
relegated to the background in modern times due to its impracticability.
3. Opportunity Costs:
The concept of opportunity costs was first systematically developed by
Austrian School of Economics. Later on, it was popularized by American
economist named Davenport. It is also known as the alternative cost or
transfer cost. In simple words, opportunity cost is the cost of production of
any unit of commodity for the value of factors of production used in
producing other unit.
For instance, a farmer can grow both the potatoes as well as garlic on a farm.
On a farm of two hectares, the farmer grows only potatoes and foregoes the
production of garlic. Suppose, the price of the quantity of potatoes is Rs.
5000, the opportunity cost of producing the garlic will be Rs. 5000. In this
way, the price of garlic which he has to forego to produce is called the
opportunity cost of potatoes.
Here, one thing is worth-mentioning that if a factor of production has no
alternative use; in that case its opportunity cost will be zero. According to
Prof. Benham, “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.”
Assumptions of Opportunity Costs:
1. Perfect competition and full employment prevail in the economy.
2. Factors of production are fixed.
3. Only-two goods can be produced in the economy.

The concept of opportunity cost can be explained with the help of figure 1.
In Figure 1, line AB represents the different combinations of two goods i.e. X
and Y which have to be produced in the economy with given resources. At
point L on AB line, the producer will produce OX units of goods X and OJ of
good-Y.
Now, if the producer wishes to produce more units of good-X than before, in
that case he will have to produce less units of good-Y. As given in the fig., at
point M, more units of commodity-X (OX1) can be produced, but less units of
commodity-Y i.e. OK. In this way, we can say that in order to produce
XX 1 units of commodity-X, the producer will have to sacrifice JK units of
commodity-Y.
Marginal Cost
Marginal cost is the cost of one additional unit of output. The concept is used to determine the
optimum production quantity for a company, where it costs the least amount to produce additional
units. It is calculated by dividing the change in manufacturing costs by the change in the quantity
produced. If a company operates within this "sweet spot," it can maximize its profits. The concept is
also used to determine product pricing when customers request the lowest possible price for certain
orders.
Accounting Cost
Accounting cost is the recorded cost of an activity. An accounting cost is recorded in the ledgers of a
business, so the cost appears in an entity's financial statements. If an accounting cost has not yet
been consumed and is equal to or greater than the capitalization limit of a business, the cost is
recorded in the balance sheet. If an accounting cost has been consumed, the cost is recorded in the
income statement. If cash has been expended in association with an accounting cost, the related cash
outflow appears in the statement of cash flows. A dividend has no accounting cost, since it is a
distribution of earnings to investors.

The scope of an accounting cost can change, depending on the situation. For example, a manager
wants to know the accounting cost of a product. If this information is needed for a short-term
pricing decision, only the variable costs associated with the product need to be included in the
accounting cost. However, if the information is needed to set a long-term price that will cover the
company's overhead costs, the scope of the accounting cost will be broadened to include an
allocation of fixed costs.
Costs are mainly of the following types:
1. Total cost
2. Average cost
3. Marginal cost.
I. Total Cost:
According to Dooley, “Total cost of production is the sum of all expenditure
incurred in producing a given volume of output.” In other words, the amount
of money spent on the production of different levels of a good is called total
cost. For instance, if a total sum of Rs. 2500 is spent on the production of 100
bicycles, then the total cost of producing 100 bicycles will be Rs. 2500. Since,
there are two types of factors of production in the short run, so there are two
types of costs.
Fixed Costs or Supplementary Costs:
The cost that remains fixed at any level of output is known as the fixed cost.
These costs must be paid whether there is production or not. These costs
include, depreciation allowance, interest on fixed capital, license fee, salaries
to permanent staff etc.
In the words of Anatol Murad, “Fixed costs are costs which do not change
with change in the quantity of output.” These costs are also known as the
overhead costs or indirect costs because a firm has to incur these costs even if
it shuts down temporarily. Thus, fixed costs are unavoidable which occur even
at the zero level of output.

Fixed cost can be shown with the help of a table 1 and diagram 2:
In Figure 2 quantity has been measured on horizontal axis while costs on
vertical axis. As is clear from the fig. 2 that even at zero level of output a firm
has to incur fixed costs equal to OP. In the figure, output increases from
OX1 to OX2 to OX3 but the fixed costs remain the same.
Variable Costs or Prime Costs:
Variable costs refer to those costs which change with the change in the volume
of output. These costs are unavoidable or contractual costs. Marshall called
these costs as “Prime Costs”, “Direct Costs” or “Special Costs”. Variable costs
include expenditure on transport, wages of labour, electricity charges, price of
raw material etc. Thus, according to Dooley, “Variable costs are one which
varies as the level of output varies.” It can be explained with the help of a table
2 and figure 3.

In Figure 3 variable cost curve starts from zero. It means when output is zero,
variable costs are also zero. But as the output increases variable costs also
increase. As is evident from the fig that when output is 1 unit variable costs
are Rs. 20. But, as the output increases to 3 units, variable costs also increase
to the tune of Rs. 2.
Relation between Total, Fixed and Variable Costs:
In order to determine the total costs of a firm, we aggregate fixed as well as
variable costs at different levels of output i.e.
TC = TFC + TVC
TFC = TC – TVC
TVC = TC – TFC

In table 3, when output is zero, variable costs are also zero. But the fixed costs
as well as total costs are 40. As the output increases to 8 units, total costs go
up to 86. It means as the output increases fixed costs remain the same, but
variable costs increase at a diminishing rate then at constant rate and
ultimately at an increasing rate. The relationship has been shown in diagram
4.
In Figure 4 quantity is measured on horizontal axis while costs on vertical
axis. KK is fixed cost curve which is parallel to horizontal axis which signifies
the fact that at all levels of output, fixed costs remain the same. VC is the
variable cost curve.
It is of the shape of reverse S. It means as the output is zero variable costs are
also zero. But as the output increases, variable costs also start increasing,
initially at diminishing rate, constant rate and then at an increasing rate.
Importance of Distinction between Fixed and Variable Costs:
This distinction is important in price theory. Every firm has the object to
maximize profits or minimize losses, if losses are unavoidable. At times the
price of the product may not cover average total cost. Then the firm will have
to decide whether to shut down or produce some output.
1. Decision to Shut Down the Firm:
The producer may not cover the total costs, if the price of the product is less
than the short-run average cost. Then the distinction between fixed cost and
variable costs must be kept in mind. Fixed costs are incurred even at zero
output. They are unavoidable costs. Variable costs are incurred only when
some output is produced.
If the price does not cover average variable costs, the firm prefers to shut
down. In other words if the total revenue (total sale proceeds) does not cover
total variable costs, the firm must shut down. Otherwise, its total loss will be
greater than the fixed costs. It will produce something only when the price
covers average variable cost and part of the average fixed costs. The output at
which marginal cost is equal to marginal revenue keeps losses minimum.

2. Break-Even Point:
At times the firm may not make any profit. It just pays to produce a given
output. Total revenue is just equal to total cost. The firm has crossed the
losses zone and is about to enter the zero profit zone. The output at which
total revenue becomes equal to total cost represents break-even point.
II. Average Cost:
According to Dooley, “The average cost of production is the total cost per unit
of output.” In other words average cost of production is the total cost of
production divided by the total number of units produced.
Suppose, the total cost of producing 500 units is Rs. 1000, the
average cost will be:
Average Fixed Cost:
Average fixed cost is the total fixed cost divided by the number of units of
output produced.
Thus:

Since, total fixed cost is a constant quantity, average fixed cost will steadily
fall as output increases, thus, the average fixed cost curve slopes downward
throughout the length. It can be shown with the help of a figure 5.
In Figure 5 the average fixed cost curve slopes downward with a view to touch
the horizontal axis. But it will not be so because AFC can never be zero. Thus,
it is clear that as output increases, average fixed costs go on diminishing.
Average Variable Costs:
Average variable cost is the total variable cost divided by the number of units
of output produced.
AVC = TVC / Q
AVC = Average variable costs.
TVC = Total variable costs Q = Output
Generally, the AVC falls as output increases from zero to the normal capacity
output due to the law of increasing returns. But beyond the normal capacity
output, the AVC will rise steeply because of the operation of the law of
diminishing returns as has been shown in figure 6.

In Figure 6 the average variable cost curve assumes the U- shape. Initially, the
AVC curve falls, after having the minimum point the curve starts rising.
Relation between Average Cost, Average Fixed Cost and Average Variable
Cost:
Average cost is the lateral summation of average fixed and average variable
cost.
The following table & fig. expresses their relationship:
Average cost can be calculated by dividing total cost with units of output (q).
In the above table AFC diminishes with the increase in production whereas
AVC diminishes up to third unit. Total average cost is minimum at fourth unit
after that it starts increasing because AVC is also increasing. Fig. 7 shows that
average cost curve is of U-shape.
Why the short-run AC is curve U-shaped?
In the short-run average cost curves are of U-shape. It means, initially it falls
and after reaching the minimum point it starts rising upwards. It can be on
account of the following reasons.

1. Basis of Average Fixed Cost and Average Variable Cost:
It is well known, that average cost is the aggregate of average fixed cost and
average variable cost (AC = AFC + AVC). To begin with, as production
increases, initially the average fixed cost and average variable cost falls. But
after a minimum point, average variable cost stops falling but not the average
cost. It is due to this reason that average variable cost reaches the minimum
before AC.
The point, where AC is minimum is called the optimum point. After this point,
AC begins to rise upward. The net result is the increase in AC. Therefore, it is
only due to the nature of AFC and AVC that AC first falls, reaches minimum
and afterwards starts rising upward and hence assume the U-shape.
2. Basis of the Law of Variable Proportion:
The law of variable proportion also results in U-shape of short run average
cost curve. If in the short period variable factors are combined with a fixed
factor, output increases in accordance with the law of variable proportions. In
other words, the law of ‘Increasing Returns’ applies.
Similarly, if we employ more and more variable factors with fixed factors the
law of Diminishing Returns is said to apply. Thus, it is due to the law of
variable proportions that the average cost curve assumes the shape of U.
3. Indivisibilities of the Factors:
Another reason due to which the average cost curve forms U-shape is the
indivisibilities of factors. When in the short-run a firm increases its
production due to indivisibilities of fixed factors, it gets various internal
economies. It is these economies which cause the average cost curve to fall in
the initial stage. Generally, there are three types of internal economies which
help to bring down the cost viz., technical economies, marketing economies
and managerial economies.

III. Marginal Cost:
The concept of marginal cost of production is recently developed by Austrian
School of Economics. Marginal cost is an addition to the total cost caused by
producing one more unit of output. For instance, the total cost for the
production of 100 units is Rs. 5000. Suppose the production of one more unit
costs Rs. 5000. It will be called the marginal cost.
Why is the MC Curve of U-shape?
Marginal cost means the addition made to total cost on account of producing
one more unit of output. In the beginning, when a firm increases its output,
total costs as well as variable costs start increasing at a diminishing rate.
It is only due to the reason that in the initial stage of production law of
increasing returns applies. Moreover, in the initial stage of production, the
firm enjoys many economies which cause the MC to fall. As the output
continues, marginal cost becomes minimum, thus, ultimately starts rising.

The reason being the operation of the Law of Diminishing Returns. In short,
initially marginal cost falls and after having the minimum point it begins to
rise. Thus, it is how the MC is also of U-shape.
Relation between Average and Marginal Cost:
The relation between average and marginal cost can be explained
with the help of following table:
Main points of the relation are as under:
(1) Average Cost and Marginal Cost can be calculated from Total
Cost:
Average cost and marginal cost can be calculated from total cost. As is known,
average cost is the ratio of total cost to total output. In other words, AC is
calculated by dividing the total cost by the quantity of output. It means.
AC = TC / Q
In the same way, marginal cost can also be calculated from total cost. It refers
to an addition made to total output by producing one more unit of output.
Thus,
MC = TCn – TC n-1
MC = ∆TC / ∆Q
When average cost falls, MC also falls:
In this situation, rate of fall in marginal cost is more than fall in average cost.
In other words, when AC curve is falling, MC curve will be below it. The
reason behind this is that whereas average cost is the aggregate of average
fixed cost and average variable cost, marginal cost refers only to change in
average variable cost.
(3) When AC rises, MC also rises:
When average cost curve rises, marginal cost too rises, but rate of increase in
marginal cost is more than that of average cost.

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