Economic Analysis of Production

Contents
1. Introduction
2. Production Function
3. Cobb-Douglas form of production function
4. Different forms of production function
5. Cobb-douglas and the CES functions
6. Empirical Estimates on Production Function
7. Production Isoquants
8. ISO-Quant Map For Fixed Proportions Production
function
9. ISO-Quant Map When Five Fixed Proportions process are
Available
10. ISO-Cost Curves
11. Concept of Expansion Path
12. Measurements Of Expansion Path
13. Effect of Changes in Input Price
14. Output and Substitution Effects of a Rise in the
Price of Labour
15. Output and Substitution Effects for an Inferior
Factor
16. The Choice Of Location In Production Decision
 17. Co-efficient of localization in production decision
18. Practical Considerations in Choice in Production
Decision

Economic Analysis of Production

1. Introduction

In conventional economic analysis of production, the firm’s decision variables are

classified into two categories: input and output. An input is anything which the firm

requires for use in its productive process. An output is any commodity or service which

the firm produces or processes for sale in the market.

Related to these two categories of variables, Management’s production decision

problems may be considered to fall into five types:

(1) Where shall the production unit be located?

(2) How much, in total, shall be spent on the purchase or ire of inputs including

the location site?

(3) How shall this budgeted amount the divided among the various types of

inputs?

(4) How much of each type of input be allocated to each type of output?
 (5) How much and what quality of each final output shall the firm produce?

These questions are inter-related. First is the location decision. To locate the plant and to

obtain the factors to operate the plant, the firm has to spend money-the firm’s capacity to

finance fixed capital and working-capital expenditure is limited y the budget

constraint. In fact, the total budget decision precedes rather than follows location

decisions. At the same time, we find that in deciding the total budget, the firm takes into

consideration the location factor, the size of the plant, the scale of capacity output, the

input requirements, etc. Once the size of total budget is decided, the next question is

allocation of the budget between fixed investment and investments in working capital like

raw materials, labour and other inputs. The allocated budget and the available market

price for the inputs together would help management in deciding the quantity and quality

of inputs available for the productive process. Normally the firm produces a combination

for two or more outputs rather than a single output. Some firms produce a main product

and a by-product. Firms may look apparently specialized in one output, but it does run

many activities. As such, depending upon the size, efficiency and specificity of available

factor, the firm has to decide on the allocation of those factors among different activity

lines. It is this resource allocation decisions which will ultimately help the firm. Deciding

on the production possibilities-combination of output to be produced. The point remains;

there are a number of input-output decisions underlying the production decisions. Each of

these decision problems involves a question of choice-the choice of production site, the
choice of budget size, the choice of technique, the choice of product-mix, so on and so

forth.

2. Production Function

Once the production unit is set up, i.e., once the choice of location and layout is made, the

task is to organize the productive process, a process of combining the different productive

factors (like men, materials and machines) in some proportion os that those factors

(inputs) can be efficiently transformed into products (outputs). Decisions on input and

output cannot, of course, be taken independently. There are technological specifications

which restrict the options available to Management. The technological information is

summarized in the production function.

Q = Q (L,N,K,……….)

which states that Q is the maximum amount of an output which the firm can produce if it

combines the inputs: land, L labour, N, and capital K. The ratio of the factor-combination

depends on the form of the estimated production function. The existence of such a

function implies that the firm’s production managers or engineers have undertaken a set

of optimality calculations whereby they have examined the many alternative ways in

which the inputs L, N and K can be combined to produce an output in the different

technological processes available for use in the productive process, and that it is on the
 basis of such calculations, they have decided that Q is the maximum amount of a given

output possible with this set of inputs.

A production – function can be stated by way of a schedule or table or mathematical

equation. The production function is supposed to show maximum amount of output that

can be produced from any specified set of inputs, given the existing technology or the

“state of the art”.

3. Cobb-Douglas form of production function

The most popular form of production-function to appear in economic literature is the

Cobb-Douglas form is

Suppose Q =Q(N,K)

This means that the physical output level, Q, depends upon, or is a function of the

quantities of labour, N, and capital, K, used. Given this, Cobb-douglas form is

Q = ANAK1-a, where 0 <a <1, and A anda are constants.

Another form is the constant elasticity of substitution, CES function.

Q = B [gN-H + (1 -G) K-h]-1,H

where h>-1, and b, g and h are constants.

If ‘h’ is assumed to be a variable, then the above function may be called the variable

elasticity of substitution, VES function.

 Still another form is the fixed proportions production functions, which is

frequently called a Leontief function. This function may be represented by

Q = minimum (k/a, N/b)

Where a and b are constants and ‘minimum means’ that Q equals the smaller of the

two ratios.Finally, we may have a very simple linear production function, assuming that

the inputs are perfect substitutes so that all factors may be reducible to one single factors,

say, labour, N. then the linear production function may be stated as :

Q = aN, where a is the constant term and N stands for labour.

4. Different forms of production function

Thus, there are five different forms of production function: Cobb-douglas

(Double-log).CES, VES, Leontief fixed proportions) and Linear. The particular form of

the production function is determined by the elasticity of factor substitution. The

elasticity of factor (input) substitution is a measure of the ease with which the varying

factor can be substituted for others. The Cobb-Douglas function has a unitary elasticity of

factors’ substitution. The CES and AES functions do not assume any specific value for

the elasticity of the substitution but, as their names suggest, the former takes the elasticity

as a constant, while the latter allows it to vary. Leontief function assumes zero elasticity

of substitution, i.e., the factors are not substitutable at all, they are to be combined in

fixed proportion. On the other extreme, the linear function assumes infinite elasticity of
 substitution, i.e. the factors are perfect substitutes. In reality, factors of production may be

substitutes, but they are not perfect substitutes. This means that from the standpoint of

real world practice, we can safely rule out the Leontief and the linear forms of production

function. Out of the remaining three, a lot of empirical work has been undertaken with

reference to the Cobb-Douglas form and the CES form. Accordingly, we will confine our

analysis to these two forms only.

5. Cobb-douglas and the CES functions

Both the Cobb-douglas and the CES functions have been presented in their linearly

homogenous form. The mathematical term ‘linear homogeneity’ means constant returns

to scale in economics. When all inputs are increased together in the same proportion, i.e.,

When all inputs are increased together in the same proportion, put is also expanded in the

same proportion. Consider, for example, the Cobb-Douglas function

Q = Q(N,K) = AnaK1-a

Let both N and K be increased by the proportion . One then has Q(

= A (λNa) (λK)1-a

= Aλa Na λ1-a K1-a

= Aλa λλ1-a Na K1-a

= λ [ANa K1-a]

= λ [Q(n,K)]

= λQ

Thus if all the inputs are expanded by λ proportion, the output also expands exactly by λ

proportion. This is precisely what is meant by constant – returns to-scale.

The other essential feature of linear homogeneity with regard to production function is as

follows: the average and marginal products depend upon the ratio in which the inputs are

combined products depend upon the ratio in which the inputs are combined but their

values are independent of the absolute magnitude of the inputs. Again consider the Cobb-

douglas faction

Q = ANA K1-a

then average product of labour

APN = Q/N = ANaK1-a/N = ANa-1 K1-x = a (K/N)1-a

This clearly shows that the average products of N depends only upon the input ratio or

what may called factor-proportions. For example, suppose A = 100, a = 1/2 . If K = 4 and
N = 1, the average product of N is 200. If K = 800 and N = 200, the input ratio is the

same and so is the magnitude of the average product.

The same relation holds true for the marginal product. Let us consider the marginal

product of labour, keeping capital, K, constant.

MPN = ∂Q/ ∂N =a AK1-a Na-1 =a A (K/N)1-a

This also shows that the marginal product depends on the input ratio or what is called

“factor intensity.

These propositions concerning average-and-marginal product function can be verified

with regard to the CES function which is also homogeneous of degree one:

Q = B [gN-h + (1 - g) K-h]-1/h

= BN [g + (1 - g) (N/K)h]-1/h

then

APn = Q/N = B [g + (1 - G) (N/K)H]-1/h

and
 MPN = ∂Q/∂N = gN-(1+h) Q[gN-h + (1 - g) K-h]-1

= gB-h [Q/N]1+h

The two properties of linear homogeneous production function can be restated

(1) It reveals constant returns to scale.

(2) The average and marginal product functions depends only on the input ratios (not on

the absolute amount of inputs).

6. EMPIRICAL ESTIMATES ON PRODUCTION FUNCTION

There is no dearth of empirical works on production function. Theoretically, the

production function relates the output Q in real terms to its inputs F in real terms. The

inputs include labour (N), capital (K), land (L), technical progress (T), raw material etc.

we may also have ‘scale’ as efficiency factors. The relative importance of these factors

differs depending upon the specific nature of the productive process and pattern, for

which a production function is being estimated. Normally, the output in period t is

expressed as a function of inputs in period t. : , where F is a Vector, F = (L,N,K,T etc), an

important point to note which is relevant for estimation is that the production function

represents a technological (engineering) relationship between flow variables rather than

stock variables. Thus the estimation of a production function requires a measure of each

of the flow of final output, labour, capital and technical progress.

 The most popular form of production function which is empirically found is the Cobb-

douglas type. We will quote, for example , two studies attempted in the Indian context:

one with reference to the sugar industry (1946-66), and the other with reference to

agriculture (1891-1961).

7. PRODUCTION ISOQUANTS

For resolving the question of choice of production technique, the production function is

not the only information required. We need to know also-the preference function of the

Production Manager and cost structure of inputs. Given the technological constraints

imposed by the production function, the producer’s indifference map can express the

scale of preference of the producer. Just like consumer’s indifference curves, we can

speak of producer’s iso-quants. An iso-quant represents different input combinations, or

input ratios, that may be used to produce a specified level of output. For movement along

an iso-quant, the level of output remains constant and the input ratio changes

continuously. A ray from the origin defines a specific, constant input ratio. For

movements along a ray, the level of output changes continuously and the input ratio

remains constant.

In the diagram given below, the two axes measure the quantities of inputs and the

curves show the different input combinations that can be used to produce 100, 200, 300

and 400 nuts of respectively. As is obvious, the further northeast a curve lies, the greater

is the output associated with it.

Consider first the iso-quant for 100 units of output. Each point on this curve shows a

capital-labour combination that can produce 100 units of output. For example, OK1 units

of capital and ON1units of labour may be used, or OK3 units of capital and ON3 units of

labour, or any other input combination found by dropping perpendiculars to the axes from

a point on the curve.

A ray from the origin, such as OAB or OA’B’C’, defines a constant capital-labor

ratio. In particular, the slope of the ray is the input ratio. For example, at points A and B,

100 and 200 units of output respectively are produced at the capital-labor ratio

OK1/ON1. Similarly, at points A’, B’, and C’, 100, 200 and 300 units of output,

respectively, are produced at the capital labour ratio OK3/ON3 = OK5/ON5.

Along the ray OAB, various levels of output are producible by the same input

ratio, the magnitude of the inputs increases as one moves out the ray but the capital-

labour ratio remains unchanged. This contrasts clearly with movements along an

isoquant. In this case, the level of output remains unchanged and the capital-labour ratio

changes continuously. Let the production function be Q = Q(N,K). The different input
combinations that produce Q units of output can be found by solving QK, N = K and N.

This expression is the equation for the iso-quant associated with Q units of output. The

iso-quant map is generated by allowing Q to vary over all possible output values.

Alternatively, the iso-quant may be determined form the following differential equations:

To illustrate, suppose Q(N,K) takes the Cobb Douglas from

Q = ANα K 1-α

Where A and a are positive constants and 0 < a <1. Then

Equation may be solved to obtain

[dk/dN] works out to be a ratio of marginal productivity of labour (MPn) to the marginal

productivity of capital (MPk). In economics, this ratio of marginal productivities is termed

 “marginal rate of technical substitution” (MRTS); in mathematical terms, this is the slope

of the iso-quant. Also note that the marginal rate of technical substitution for a linear

homogeneous production function boils down to a product of input elasticity – ratio (a/1-
a
) and input ratio (K/N). Like diminishing marginal rate of substitution between factors so

that the iso-quant or iso- products curves are negatively sloped.

Using the iso-quant device, it is easy to illustrate the case of Leontief fixed proportion

product functions or what is called input-output iso-quant. The iso-quant for fixed-

proportion process are L-shaped curves. This illustrates, for example, that if 2 units of

labour and 2 units of capital are employed, 100 units of output are obtainable. However,

if the quantity of capital is expanded, if its usage is expanded while the other input is held

constant, output is unchanged. In other words, the marginal production of either labor or

capital is zero. On the other hand, doubling inputs at the required ratio trebles output.

8. ISO-QUANT MAP FOR FIXED PROPORTIONS PRODUCTION

FUNCTION-
LEONTIEF PRODUCTION FUNCTION
 A rather realistic case is that in which many, but not an infinite number of different fixed

proportions processes are available. In this case, we get kinked iso-quant. The reader may

note that BACDE straight lines have been drawn to connect the different possible input

combinations in Fig. V.6c Each of the points on this kinked line represents an input

combination capable of producing 100 units of output.

9. ISO-QUANT MAP WHEN FIVE FIXED PROPORTIONS

PROCESS ARE AVAILABLE
Suppose there are many fixed-proportions process by which a given level of output can

be produced. Instead of the five points in Fig. V.6c there would be many points.

Similarly, there would be many line facets of the type AB, BC, etc. As the number of

processes increases, the kinked line looks more and more like a typical iso-quant. Indeed,

an iso-quant depicting a variable-proportions production function is just the limiting case

of fixed-proportions processes as the number of process increases without bonus. This

argument, in fact, constitutes one rationale for the use of smooth iso-quant and variable

proportions production functions in economic theory. Many manufacturing processes

may be characterized by fixed or almost fixed proportions; however, usually many

different fixed-proportions processes are available constructing smooth iso-quant rather

than multiple facet lines simplifies analysis while leading to relatively unimportant

departures from real world conditions. The chief difference is that with smoothly

continuous iso-quant, any desired capital-labour ratio can be attained (if it is feasible) by

using one process, a desired combination may require the proper mixture of two

processes. We may also get linear isoquant, if factors are perfect substitutes. Assuming

continuity in the choice of technique and factor substituting up to certain limit, we get

smooth convex isoquant

10. ISO-COST CURVES

Inputs just as outputs bear specific market price. In determining his operating input

combination, the production manager must pay heed to relative input prices. The input
prices are determined, just as output prices, by the interaction of the market forces of

demand and supply. Let us continue to assume that there are two inputs, Labour and

Capital, the quantity of which can be denoted by N and K respectively and their unit

prices by Pn and Pk. The total cost of using any combination of N and K is

C = PN N + Pk. K

The sum of the cost of N units of labour at Pn price per unit i.e. wage rate, and of K units

of capital at PK price per unit i.e., interest rate. If the budget is specified by Management,

the C = C-

Therefore, C- = PN. N + Pk' K

Or PN. N = C- - PK K

N = C-/PN - Pk/PN K …..(I)

Exactly, in the same fashion, we can derive

K = C-/PK - PN/PK N …….(II)

 In (i) and (ii), we have the equation of an iso-cost curve in the slope-intercept

from.

If Management decides to spend the entire budget C- on labour, N, [i.e., in (i) K = 0], the

C- /PN amount of N can be employed. On the other hand, if Management decides to spend

the entire budgeted amount C on capital, K, (i.e., In (ii) N = 0), then C-/Pk amount of

capital can be purchased. Thus C-/Pk and C-/Pn are the ordinate intercepts in the diagram

V. 7a. The slope of the iso-cost curve is denoted by input price ratio PN / PK OR PK/PN

which is negative. The iso-cost curve ML satisfying the linear equation indicates all

possible combinations of labour and capital which can be purchased out of given

budget given the input prices, PN and PK. When the budget remains fixed, more labour

can be purchased only if less capital is purchased. So long as the budget remains a

stipulated amount of expenditure, labour and capital are assumed substitute factors.

11. THE CONCEPT OF EXPANSION PATH

The level of optimal factor proportions may change when output or factor-price ratio

changes. Let us assume that the input prices do not change, but size of available budget to

be spent on the input does change. Since input prices do not change, the relative input

price structure is not affected. This means that the slope of the iso-cost curve remains the

same. Under these circumstances, any change in the level of expenditure on inputs and

hence in the level of output can effectuate a shift in the iso-cost curve. For example, if the

top management decides to spend more on inputs: labour and capital, and if wage rate

and interest rate have not changed, then there will be a parallel rightward shift in the iso-

cost curve. As the there will be a parallel downward shift in the iso-cost curve. As the

iso-cost curve thus shifts upward or downward, the point of producer’s equilibrium,

satisfying the decision rule of proportionality may also change. For example, in Figure V.

9a when the iso-cost curve shifts from ML to M’L’, the equilibrium point shifts from e to

e’; when the iso-cost curve shifts from ML to M”L”, the equilibrium points shifts from e

to e”
The locus of these equilibrium points is traced out by a curve called the expansion path

which shows how factor proportions change when output or expenditure changes, input

prices remaining constant throughout. If expenditure has gone up such that the producer

can buy either MM’ of additional capital or LL’ of additional labour-then the factor

combination has changed form (OK+ON) to (OK’ + ON’). In case of constant returns to

scale, the expansion path OE will be a straight line, which reflects that factor proportions

are independent of the level of output. The shape of the expansion path changes

depending upon the type of returns to scale prevalent. It is the expansion path which is

critical in determining the long-run costs of production.

12. Measurements Of Expansion Path

We may now take a problem and solve it to illustrate the concepts and measurements of

expansion path, derived demand and supply functions. Suppose a production unit which
uses two factors labour (N) and capital (K) to manufacture an item Q, is found to have the

production function:

E = Q + λ [ WN + RK - C-]

= 6 LOG N + 12 LOG K + λ [12N + 36K - C-]

Taking the relevant partial derivatives we obtain

Multiplying the first equation through by 3 and subtracting the second equation from it,

we have

[18/N - 12/K] = 0 or 18 K = 12N

or K = 2/3 N
Direct substitution then yields the solution for K, N and λ in terms of C- Refer the

expenditure constraint.

C- = W.N + R.K

12N + 24 N

Since K = 2/3 N,

C- = 12N + 24N

∴ N = C-/36

Similarly if K = 2/3 N or N = 3/2 K

Then C- = 12N + 36K

= 18K + 36K

∴ K = C-/51

Similarly if [5/N + 12λ] = 0

then 12 λ = - 6/N ⇒ λ = - 1/2N

Since N = C-/36
λ = -1/2N = -18/C-

Thus K = C- /54; N = C-/36 and λ = - 18/C-

These results constitute the required expansion path relationships indicating the amount

of each input bought as a function of total expenditure, C- For example, other things

remaining equal, if the production unit is allowed to spend 1944$ (= C-), then

K = 36, N = 54 and λ = 1/108

Using the production function and input prices of the preceding problem, we can

determine the supply function of the product, Q, whose price may be taken to be an

unspecified constant, Pq. In the process of derivation of the supply function, we can also

get the derived demand function. Let us assume that out production unit is interested in

maximizing profit subject to the constraint imposed by the production function. In this

case, to derive the solution for the decision variables, the relevant lagrange expression

will be

L = π + [Q - (6 log N + 12log K)]

= Pq Q - 12N - 36K + λ [Q - 6log N - 12 log K]

The relevant partial derivatives at its maximum are

These equations clearly yield the solution which is as follows:

since λ = -Pq, N = Pq/2 and K = Pq/3

Plugging in the values of N and K in our production function we get

Q = 6 LOG Pq/2 + 12 LOG Pq/3

Thus we have the supply function: the supply of output Q as a function of the price of

that output Pq. We have also got the derived demand functions for two inputs: the demand

for input (labour, N or capital, K) as a function of Pq, the price of the output which is

produced with the help of labour and capital.

13. EFFECT OF CHANGES IN INPUT PRICE :

From demand analysis we know, a change in the price of a good has two discernible

effects: the substitution effect and the income effect. The substitution effect is always

negative and the income effect is normally positive and reinforces it. Much the same

type of effects may be isolated for changes input price.

First consider Figure V. 10 a This graph illustrates increases in the price of labour inputs,

the price of the capital input remaining constant. The original factor-price ratio is given

by the slope of the iso-cost curve KN1. As this iso-cost curve shifts leftward to KN2 to

KN3, the price of labour inputs, the price of the capital input remaining constant. The

original factor-price ratio is given by the slope of the iso-cost curve KN1. As this iso-cost

curve shifts leftward to KN2 to KN3 the price of labour increase because the same total

expenditure on labour will at first purchase ON1 units, than ON2 units and finally ON3

units. The change in input price generates the substitution and output effects. The

substitution and output effects are shown n Fig. V.10b The original point of equilibrium

is Q. The level of output is indicated by the isoquant I1, the input price ratio by the slope
 of the iso-cost curve KN1, and initially OK1 units of capital and ON1 units of labour are

used. Now let the price of labour increase, the price of capital remaining unchanged. This

shifts the iso-cost curve to KN2. If the producer maximizes the output attainable for this

given cost, the equilibrium point changes from Q to S, the level of output failing to that

indicated by the iso-quant I2. In this ultimate equilibrium position, OK2 units of capital

and ON3 units of labour are used. The total effect of the wage rate change on labour usage

is, therefore, a decrease from On1 to On3 or a reduction of n1-n3 units of labour.

14. OUTPUT AND SUBSTITUTION EFFECTS OF A RISE IN THE

PRICE OF LABOUR

The total effect may be decomposed into two components. The change in labour usage

attributable exclusively to the change in the relative input price is called the substitution

effect. To determine this effect graphically, construct the fictitious iso-cost line K’N. This

line is constructed so that there is a fictitious equilibrium at the out output level and the

new input prices. In other words, the rise in input prices has been compensated by an
increase in expenditure sufficient to maintain the old level of output. A fictitious

equilibrium is reached at point R and the movement from Q to R represents the

substitution effect, i.e., the change in input usage attributable only to the change in

relative input prices, the level of output remaining constant. In input usage, the

substitution effect reduces labour input from On1 to On2, or by the amount n1-n2 and

capital usage form Ok1 Ok, or by K1-k. When an input price increases, however, there

must be a decrease in output if the level of expenditure does not increase. The output

effect is represented by the shift from the fictitious equilibrium point R on I1 to the

ultimate equilibrium point S on I2. The output effect leads to a reduction in labour

input from On2 to On3 or by the amount n2-n3. Capital usage is also reduced by the output

effect, from Ok to Ok2, or by k-k2.

The effect upon labour usage attributable to the rise in the price of labour is simply the

sum of the two effects:

n1 – n3 = n1-n2 + n2-n3

(total effect) = (substitution effect) + (output effect)

15. OUTPUT AND SUBSTITUTION EFFECTS FOR AN

INFERIOR FACTOR
The effect of a change in the price of an input upon the usage of this input may be

decomposed into two components. The substitution effect shows the change in input

usage attributable exclusively to the change in relative input prices, output being held

constant. This effect is always negative in that a rise in input price leads to a reduction,

and a fall in input price to an increase in the usage of the input. The output effect shows

the change in input usage attributable exclusively to a change in the level of output, input

prices remaining constant.

Just as there may be inferior gods, there may be in inferior factors of production, and just

as the former is associated with negative income effect, the latter is associated with a

negative output effect. The case of inferior factor is illustrated in figure

16. OUTPUT AND SUBSTITUTION EFFECTS FOR AN

INFERIOR FACTOR
The initial equilibrium is at Q on I1, where the slope of the iso-cost KN1 indicates the

factor price ratio and On1 units of labour are employed. Now let the wage rate rise so as

to rotate the iso-cost curve to KN2. The point of equilibrium shifts to S on I2 and the

usage of labour expand to On3. To see the components of the change, construct the

fictitious iso-cost curve K’N’ so that it is tangent to the original iso-quant but has a slope

reflecting the new price ratio. The tangency occurs at R, and it shows the combination of

inputs that would be used if the old level of output were produced at the new input price

ratio, movement from Q to R, or the decrease from On3 to On2 is the substitution effect,

and as in all cases, it is negative. That is, the quantity of an input demanded varies

inversely with its price for movements along an iso-quant.The movement from the

fictitious equilibrium at R to the proper equilibrium at S or the increase from On 2 to On3,

represents the output effect fo the wage rate change. In this case, it is negative: the

production in output from the I1 level to the I2 level causes an increase in the usage of the

factor. Thus with an increase in the price of labour the use of labour has increased by n1-

n3. So labour is said to be an inferior factor. Thus, “an in inferior factor of production is

one that has a negative output effect” (Ferguson)1 or what is called “regression relation”

17. The Choice Of Location In Production Decision

Theories

A very important decision affecting production is the location and layout of the

production unit. Based on investigation and analysis. Alfred Weber classifies the causes

influencing location into two categories : (1) Primary causes of regional distribution of
industry : ‘regional factors’ and (2) Secondary causes responsible for redistribution of

industry – ‘agglomerating and degglomerating’ factors.

Looking at the cost structure of different industries, Weber discovers the regional factors

affecting industrial orientation – (a) transportation costs, determined by (i) weight to be

transported and (ii) distance to be covered, and (b) labour costs. The actual basis on

which production will get oriented within a location figure depends upon two conditions-

the type of raw materials used and the nature of third transformation into product. Some

raw materials water, clay and bricks are ‘ubiquitous’ i.e., available everywhere; some like

coal and iron are ‘localized’. The localized materials, exercise a greater influence on

location than ubiquitous materials. Some raw materials are ‘pure’ (e.g. cotton), others are

‘weight losing e.g. minerals). The production unit tends to get localized near the source

of ‘localized’ and ‘weight losing’ materials. On the basis of these observations, Weber

deduces the laws of transport orientation. The proportion of the weight of localized

materials to that of final product is called the ‘Materials Index.’ If the material index is

high, production tends to be attracted to the places of deposit of the materials. If low, it

tends to be attracted to the market where the product is sold. Any deviation of the

production unit from the centre of least transportation costs so decided, is caused by

labour costs. The extent of deviation is determined by the ratio of ‘Labour Cost Index’

(=the proportion of labour costs to total weight of the product) to the ‘Location Weight’

(=weight to be transported during the whole process of production); this ratio is called

“labour co-efficient.”
A deviation from the centre of the least transportation cost may also take place due to the

operation of agglomerative and degglomerative factors. Agglomeration refers to

advantages due to concentration of an industry. The opposite tendency of degglomeration

leads to cost-reduction due to decentralization. The power of agglomlocations depends on

the ratio of ‘Location Weight’ to the ‘Index of Manufacture’ this ratio is called the “co-

efficient of manufacture. (=manufacturing costs)/(total weight of the product) A high

coefficient of manufacture encourages agglomeration and vice versa. Weber has also

considered the possibility of a split in location, particularly when different stages or

processes of production in an industry or firm, can be carried on independently and at

different places.

Weber’s deductive theory has provoked many criticisms. Dennison thinks that location

must be explained in terms of price cost considerations rather than technical co-efficient.

Weber presents a mechanical model. Predohl argues that Weber’s theory is more

selective than deductive: why should ‘labour costs’ and ‘transportation cost’ alone be

regarded as “general factors”, and the “capital costs” or “management costs” should also

be considered. Robinson does not accept Weber’s raw material classification, because in

reality materials are drawn from a large number of alternative unrealistic. For example,

labour centers and consumption centre are never ‘fixed’ ; these centres constitute cause as

well as effect of the locational change. Florence thinks that a proper location theory must
 consider the role of social and historical factors; the approach must be inductive and

analytical.

Sargent Florence’s inductive analysis of industrial location has assumed a great practical

significance recently. He does not accept location to mean “a relation between industry

and geographical is not so important as the relation of the industry to the distribution of

the occupied population as a whole.” Basic to his theory of location, two new concepts

have been introduced: “Location Factor” and “Co efficient of Localization”.

Location factor: It is an index of the degree of concentration of an industry in a particular

place. This index is arrived at by taking the percentage of all workers in a particular

industry found in a certain region and dividing it by the proportion in that particular

region of the total industrial workers in the country. The underlying idea of such an index

is that location should be explained as the degree of dissimilarity between the

geographical distribution of the industry and the population of the country. If an industry

is evenly distributed over the whole country, the location factor for each region would be

unity, because the proportion of the total industrial workers of the region would be equal

to the proportion of workers in a particular industry. In case industry is not evently

distributed; the location factor will be either above or below unity.

18. Co-efficient of localization in production decision

It indicates the propensity of an industry to concentrate: an industry’ tendency for

localization anywhere in the country. It can be worked out for an industry from the

Census of Production by the following formula. When workers are divided up region by

region as percentages of the total in all regions, the co-efficient is the sum (divided by

100) of the plus deviations of the regional percentage of workers in all

industry. Complete coincidence, region by region of the particular industry with all

industry gives a co-efficient of O, extreme differentiation (e.g. workers in the particular

industry being all concentrated in that region) gives a figure approaching 1.

The object of arriving at such an index is to classify industries according to their qualities

of dispersion or concentration. On the basis of the co-efficient of localization, all

industries of a country can be divided into three categories of high, low and medium co-

efficient thrive industries. Industries with a low coefficient of localization can thrive in

different regions and are thus dispersed. Industries which show a high co-efficient of

localization like coal mining and other mineral industries are centralized in particular

regions.

The inductive approach of Sargent Florence based on the two statistical indices has been

criticized as follows: 1) These coefficients given by Sargent Florence only reveal the

existing state of distribution of industries in a particular country. They are incapable of

explaining the reasons for particular form of concentration. 2. The location factor is not
always a sure guide of the degree of concentration of an industry because it is based on

the number of industrial workers employed in each area. A better basis of comparison

may be the output in each area, because i) labour may differ in efficiency and ii) capital

may be substituted for labour. Hence the output basis is more scientific than the

employment basis.

But the indices prepared by Sargent Florence are of immense significance for studying

the location dynamics in any country. The indices are an invaluable guide for analyzing

the trends of industrial development in a country. Some have felt that there should be a

judicious combination of the pure theory of Weber with the indices provided by Sargent

Florence to enunciate a policy of scientific location of industries for a country. Even then

some limitations will remain because both of these approaches are based on the capitalist

structure of societies where cost considerations predominate over welfare

considerations. If industrial location is influenced by cost consideration alone, then there

may a divergence between marginal private and social net products. Interest has been

taken in the study of locational dynamics not only for analyzing the present framework of

industrial orientation but also for formulating a realistic policy of location

planning. Hence the socialist cannot accept these theories as guide to their policy. They

have felt the need for locational planning-individual locations must be planned so that

different regions may have balanced growth. Socialist planner have now worked out

investment criteria for such planning.

There is need for some kind of regional planning of industry which should aim not only

at maximum efficiency of an industrial unit but also at an optimum distribution of

industrial activity based on roader economic, social and strategic considerations.

19. THE CHOICE OF LOCATION IN PRODUCTION DECISION

Practical Considerations

The location of production is determined by a great complexity of practical

considerations namely, historical, economic, natural and often psychological. Choice of

location is, therefore, the result of a balance of these factors.

Historical: In many cases, historical accidents have played an important part in affecting

the location of industry. For example, the cotton manufacture was located in Lancashire

not because of economic reasons but because of historical and accidental factors.

Availability to raw materials: The proportion of the localized materials to the final

product which has been called the “material index” by Weber is an important factor

influencing the degree of concentration. The higher the index, the greater

the concentration of that industry at the centre of raw material. The cotton textile industry

during its initial stage was greatly influenced by the raw material, though degglomerating

tendencies acted against concentration in Bombay and Ahmadabad later on. The Tata

iron and steel industry provides another illustration of location near the deposits of raw

materials.
Access to markets: Industries whose product is costly to carry on account of fragility,

perish ability, or bulk are located in close proximity to market. This tendency becomes

more emphasized if the raw materials are less costly than transport or are derived from

diverse sources, ad loose little weight in the process of manufacture. The pull of market-

the evolution of new market is an important factor behind the dispersal of industries.

Transportation costs: The industries require transport facilities not only to get the raw

materials but also to send the final products. The industry tends to get localized in a place

where transport cost, are minimum. If the industries do not do so, it may be due to the

fact that the place of minimum transport costs is not the place of minimum production

cost. The role of business entrepreneur is to consider both production and transportation

cost. The more rapid construction of railway after 1880 synchronized with the growth of

cotton, jute and coal-mining industries. The cheap transport facilities, both for internal

and external markets, led to initial concentration of cotton mills in Bombay. The early

railway freight policy was largely responsible for the congestion of industries in the port

towns.

Power resources: Nearness to coal deposits has been an important consideration for the

various industrial units since coal involves high transport costs. But with the advent of

electricity a more flexible source of heat and power has become available. In other words,

electricity has undermined the influence of coal except in those industries in which it is
still one of the chief ingredients e.g., iron and steel industry. The development of electric

power induces the dispersal and decentralization of industries.

Labour : The availability of workers in the interior of Bombay region was one of the

factors responsible for the initial concentration of textile mills. The importance of labour

in influencing the location of industry is difficult to assess since non-availability of local

labour is not likely to prevent a site which has great natural advantages for an

industry. Labour can always be provided by immigration from other areas. The fact that

labour can be obtained at lower wage rates has lost much of its importance these days

because of national agreements relating to minimum wage, social security benefits, etc.

Site and Services: Cheapness of the value of sites and the existence of public utility

service attract industries to regions offering these facilities. On the basis of this

consideration, the Government of India has launched the scheme of developing Industrial

Estates in various parts of the country to disperse industrial activity. Social amenities

offered by the ‘Backward Areas’ as regards housing and medical facilities other an

attraction to industrial enterprises. In the pre-independence days, there was a considerable

shift of industries from British India to native states as the ruling prices provided a great

deal of encouragement and help to industries in the form of few legal formalities, lower

level of taxation and less stringent labour laws. Further, when an industry concentrates

itself within a relatively small area, important advantages often occur to it as a result of

what have been called “economics of concentration.”

Financial facilities : Financial consideration is not likely to exercise much influence on

location of industrial units. Capital is a highly mobile factor of production and it is likely

to be equally available for use in any part of the country. But under certain special

circumstances this factor may be important. The government may influence the banks to

withhold financial assistance unless the entrepreneurs concerned locate their units with

regard to the national interest, such as backward area development etc.

Natural and climatic considerations: Factors like the level of ground, topography of a

region and climate play an important role in the determination of the location of

industries associated with agricultural raw materials. Humid climate may provide an

additional advantage to certain regions to attract cotton textile industry since the

frequency of yarn breakage is low. On the other hand, artificial humidifiers have been

used in areas with non-humid climate but that use has involved additional cost.

Personal factor: Industrial entrepreneurs are not always guided by purely economic

considerations in deciding location of their industrial enterprises. Personal preferences

and prejudices of these persons are equally important.

Strategic considerations: During the recent years strategic considerations have been

emphasized in industrial location. Experience has shown that the main targets of air

attack are armament factories and industries supplying products for war purposes. Such
industries should naturally be located at places comparatively immune from air attacks.

The Carlow Commission in the U.K. Stated : “The risks of air attack, and the best means

of countering them, sought of the future to be a vital consideration not only in connection

with broad issues of the location of industry generally, but for each individual

entrepreneur or manufacture.”