Production analysis

 Production is an activity
 that transforms inputs into output.
 that increases consumer’s usability of goods and
services

 Technology:
 A firm’s production behaviour is fundamentally
determined by the state of technology.
 Existing technology sets upper limit for the production of
the firm, irrespective of the nature of output, size of the
firm or the kind of management.
 Inputs

 Time period of production

 The production function:

 Technological relationship which expresses the relation

between output of a good and the different combinations
of inputs used in its production.

 It indicates the maximum amount of output that can be

produced with the help of each possible combination of
inputs
Assumptions:
1. Technology is invariant
2. Firms utilizes their inputs at the maximum level of
efficiency

Short run analysis of production function

1. Case of one variable input
If all factors of a firm are fixed except amount of labour
services, then any decrease or increase in output is
achieved with the help of changes in the amount of labour
services used.
When firm changes the amount of labour services only, it
alters the proportion between the fixed input and variable
input.
As firm keeps on altering this proportion by changing the
amount of labour, it experiences the law of variable
proportion or diminishing marginal returns.
 Law of variable proportions:
(Law of diminishing marginal returns)
“As more and more of the factor input is employed, all other
quantities remaining constant, a point will eventually be
reached where additional quantities of varying input will yield
diminishing marginal contributions to total product.”

Find Marginal and Average Product

Labour Input Total product AverageProduct Marginal
product.
1 100
2 210
3 330
4 430
5 520
6 600
 7 670
8 720
9 750
10 760

 In table labour is assumed to be the only variable input.

 Column I and Column II represent the production function.
 Column III average combination of labour units involved.
 Column 4 lists the amount of increase in output as a result
of each additional unit of labour.
 Column four shows that the marginal physical product starts
declining from 4th unit of labour onward. If labour unit
employed beyond 10 the MPP will become zero and later
becomes negative.

 The stage from where MPP starts declining shows the law of
diminishing returns or law of variable proportions.
 MP begins to fall before the AP does.
 Reason: AP attributes the increase in TP equally to all
the units of the variable factor whereas the MP attributes the
increase in TO to the marginal unit of the variable factor.

 If MP > AP : AP rises
If MP<AP : AP falls
It follows when MP=AP the AP is at its maximum
Reason: AP is increasing, MP is above AP, pulling it up;
when the AP is at its maximum and constant. AP=MP; when
AP is falling, MP is below AP, pulling it down.

The Three stages of production

Diminishing returns to a factor can be graphically understood.

 Stage1:
- TPP curve rises first to an increasing rate and later at

a diminishing rate.(MPP and APP are rising)

 Stage2 :
- Initially TPP increases more than proportionately
until X units of labour are employed; Between X units and
Y units of labour used, the TPP rises with every additional
unit of labour but the increase is less than proportionate
( MPP and APP are declining)

 Stage 3
- TPP decreasing
-Additional units of labour makes MPP negative

 NO firm will choose to operate in stage 1 or stage 3

 In stage I MPP is rising- profitable to keep on increasing the
use of labour
 In stage III MPP is negative –inadvisable to use more labour.
Even if the cost of labour is zero it is not advised to use
additional labour.
 Stage II is the only relevant range.
 Exact number of labour units hired can be found only when
the corresponding data on wage rates is available.
TPP MPP APP

Stage I
Increases at an
Increasing Rate Increases and Increases (but
reaches its slower than MPP)
maximum
Stage II
Increases at a Starts diminishing Starts diminishing
diminishing rate and and becomes equal
becomes maximum to zero

Stage III Continues to

Reaches its Keeps on declining diminish but
maximum, becomes and becomes must always be
constant and then negative. greater than
starts declining. zero.
Stage I Stage II Stage III
Fixed inputs grossly Specialization and Fixed inputs
underutilized, teamwork continue capacity is reached ,
specialization and and result in greater additional X causes
teamwork cause output when output to fall.
APP to increase additional X is used,
when additional X is fixed input is being
used. properly utilized.
 Two variable production function

A Firm may increase its output using more of two variable inputs
that are substitutes for each other. E.g. Labour and Capital.
There may be various technical possibilities of producing a given output by
using different factor combinations .Which particular factor combination
will actually selected by the firm depends both on the technical possibilities
of factor substitution as well as on the prices of factors of production.

Short period production function if there exist some other fixed factor of
production.

Long period production function if there are only two factors of production and
both are variable.
Isoquant:

 Isoquants are a geometric representation of the production function.

 It is also known as the ISO PRODUCT curve.

 Assuming continuous variation in the possible combination of labour and

capital, we can draw a curve by plotting all the alternative combinations for a
given level of output.

 This curve which is the locus of all possible combinations is called Isoquants
or Iso-product curve.

 Each Isoquants corresponds to a specific level of output and shows different

ways all technologically efficient, of producing that quantity of outputs.

Different types of isoquants

1. Smooth curvature
2. Perfect substitutes
3. Perfect compliments
Properties of Isoquants

1. Iso-quants are downward sloping and convex to the origin.

2. Higher Isoquants show higher level of out put.
3. Isoquants do not touch the axis
4. No two iso-quants intersect each other.
5. Slope of an iso-quant indicates the rate at which factors can be
substituted for each other while a constant output is maintained.

Budget Line (Iso-cost Line):

Locus of various combinations of inputs that a producer can purchase with

his budget.

Example:
Suppose the price of one unit of labour is $10 and one unit of capital is$2.5
a. Use this information to determine the iso cost equation
corresponding to a total cost of $200 and $500.
 b. Plot these two iso-cost lines on the graph
c. If the price of labour falls from $10 per unit to $8 per
unit , determine the new $500 iso-cost line and plot it
on the same diagram used in part (b)

Marginal Rate of technical substitution

 Marginal rate of technical substitution of labour for capital may be defined

as the number of units of capital which can be replaced by one unit of
LABOUR, the level of output remaining unchanged.

 MRTS of labour for capital= ∆ K/∆ L = SLOPE

Factor combination units of labour unit of capital MRTS of L for K

A 1 12
B 2 8
C 3 5
D 4 3
E 5 2
Optimal Factor combination:

 Theory of production can be viewed from two angles which are dual to
each other
 A firm may decide to produce a particular level of output and then
attempt to minimize the cost of inputs
Or
It may attempt to maximize its output subject to a cost constraint.

 A firm spends money on two inputs say labour and capital.

It decides its budget and knows the price of each of the inputs which
remains constant.
 Slope of budget line is negative
 Slope of budget line is equal to the price ratio of the two inputs.
 The budget line of the firm has been superimposed on its isoquant map.
 The firm will be at equilibrium at the point where isoquant is tangent to
the budget line AB i.e. point “E”
 At equilibrium the firm produces on the isoquant Q2 and uses OX1 units
of labour and OY1 units of capital
At point “E”,

Slope of Isoquant= Slope of budget line

Or, MRTS= ratio of prices of two inputs.

  Thus to minimize production costs ( or to maximize output for a given
cost outlay), the extra output or marginal product spent on labour
must be equal to the marginal product per unit spent on capital.

Expansion Path

Economic region of production ( Ridge Lines)

Long run production function:

Situation where all inputs are subject to variation is a case
of Long period production function.
 In short period fixed inputs sets the upper limit for
production. In long run by definition such limitations do not
exist.
Let us consider labour and capital. These can change in
two ways-
a.Both K and L change in same proportion ( K/L
remaining same i.e. technology remaining same)
b.L and K change in different proportion ( K/L ratio or
technique of production varies with change in
output.
The percentage increase in output when all inputs vary in
the same proportion is known as returns to scale.
Returns to scale relate to greater use of inputs maintaining
the same technique of production.
When returns to scale occurs , three alternative situations
are possible:
1. Constant returns to scale
2. Increasing returns to scale
3. Decreasing returns to scale.
Units of Units of Percentag Total Percentag Returns to
labour capital e increase product e increase scale
in labour in total
and product
capital
1 100 - 100 0
2 200 100 220 120
3 300 50 350 59
4 400 33.33 500 42.9
5 500 25 625 25
6 600 20 750 20
7 700 16.66 860 14.66
8 800 14.29 940 9.3
9 900 12.5 1000 6.4
Causes for increasing returns to scale

1. Specialisation
2. Dimensional advantages

Causes for decreasing returns to scale

1Co-ordination and control become increasingly difficult.
2. Distortion of information