Microeconomics

Production analysis mod-3

Production analysis
Meaning of production: the term
production means transforming inputs (labour,
capital, raw materials, time etc.,) into an
output
This is concept of production and it is limited
to only manufacturing
In economic sense, the term production
means a process by which resources (men,
material, time etc.,) are transformed into a
different and more useful commodity or service

 In other words, production is a process by which

men, material, capital and time are converted
into value added products is called production.
In economic sense, production process may
take a variety of forms than manufacturing.
Ex. Transporting a commodity in its original
form from one place to another where it can be
consumed or used in a process of production is
production (sand dealer transporting sand to
construction site, fisherman transporting fish to
market, transporting men & material from one
place another)

 Production process does not necessarily

involve physical conversion of raw material in
to tangible goods
Some kinds of production involve an intangible
input to produce an intangible output
Ex. In the production of legal, medical, social,
and consultancy services both inputs and
outputs are intangible
Lawyer, doctors, social workers, consultants
etc., are all engaged in producing intangible
goods

 An input is a good or service that goes

into the process of production.
Inputs include 1. labour, 2. capital, 3.
land, 4. raw material, and 5.
entrepreneurship.
Technology and time are also treated as
inputs in modern concept of production
An output is any good or service that
comes out of production process

 Fixed and variable inputs: inputs are

classified into i. fixed inputs and ii. variable
inputs
In economic sense a fixed input is defined as
one whose supply is inelastic in the short
run.
Therefore all of its users together cannot
buy more of it in the short run
In technical sense a fixed factor is defined as
one that remains fixed for a certain level of
output (building, plant & machinery)

 A variable input is defined as one

whose supply in the short run is elastic
eg., labour and raw material etc.,
All users of such factors can employ a
larger quantity in the short run as well
as in the long run
Technically, a variable input is one that
changes with change in output. In the
long run all inputs are variable

 Short-run and long-run: the reference to

time period involved in production is another
important concept used in production
analysis
The two reference periods are short-run and
long-run
The short run refers to a period of time in
which the supply of certain inputs (plant,
building, machinery etc.,) is fixed or inelastic
In the short-run production of a commodity
can be increased by increasing use of only
variable inputs like labour and raw materials

 It is important to note that short-run and

long-run are economist jargon
They do not refer to any specific time period
While in some industries short-run may be
few weeks or few months, in some others
( housing, shipping, flying, electricity and
power industries) it may be three or more
years
The long-run refers to a period of time in
which the supply of all inputs are elastic, but
not enough to permit a change in technology

 That is in the long-run, all the inputs are

variable
Therefore in the long-run, production of a
commodity can be increased by employing
more of both variable and fixed inputs
In very-long-run which refers to a period in
which the technology of production is also
subject to change or can be improved
In very-long-run production function also
changes
The technological advances result in a larger
output from a given quantity of input per unit
of time

 Production function: is a mathematical

presentation of input-output relationship
A production function states the
technological relationship between input
and output in the form of an equation, a
table or a graph.
It specifies the inputs on which depends
the production of a commodity or service
It states the quantitative relationships
between inputs and output

 Production function represents the

technology of a firm, of an industry
or of the economy as a whole.
A production function may take the
form of a schedule, or a table, a
graphed line or curve, an algebraic
equation or a mathematical model
Each of these form can be converted
into its other forms

 A real-life production function is very

complex
It includes wide range of inputs viz.
Land and building
Labour including manual labour,
engineering staff and production manager
Capital
Raw material
Time and
Technology

 All these variables enter the actual production of a

firm
The long-run production function is expressed as:
Q=f(LB, L,K,M,T,t)
Where LB=land and building, L=labour, K=capital,
M raw materials, T=technology and t= time
The economists have reduced the number of input
variable used in a production function to only two
viz Capital (K) and Labour(L) for the sake of
convenience and simplicity in the analysis of
input-output relation

 A production function with two variable

inputs, K and L is expressed as
Q=f(L,K)
Reasons for exclusion:
Land and building are constant for the
economy as a whole, incase of individual
firms land building are lumped with capital
Raw material time and technology bears
constant relation with output
Also technology remains constant over a
period of time

 Short-run laws of production:

production with one variable input
The laws of production states the relationship
between output and input
The short-run, input-output relations are
studied with one variable input (labour),
other inputs (especially capital) held constant
The laws of production under these
conditions are called the laws of variable
proportion or laws of returns to a variable
input

 The law of diminishing returns: the law of

diminishing return states that when more
and more units of a variable input are used
with a given quantity of fixed inputs, the total
out put may initially increase at increasing
rate and then at a constant rate, but will
eventually increase at diminishing rates
The marginal increase in total output
decreases eventually, when additional units
of a variable factor are used, given quantity
of fixed factors

 Assumptions: the law of diminishing

returns is based on following
assumptions:
1.labour is only variable input, capital
is remaining constant
2.labour is homogenous
3. the state of technology is given and
4. input prices are given

 Illustration: assume i. a coal mining firm has

a set of mining machinery as its capital (K)
fixed in the short run and ii. That it can
employ only more workers to increase its
coal production
Thus short-run production function Q c=f(L),K
Assume the labour-output relationship is
given by a hypothetical production function
Qc=-L3+15L2+10L by substituting values
for L labour we can get the output Q c

 Marginal productivity of labour: can be

obtained by differentiating production function
thus
MPL= Q/ L= -3L2+30L+10 by substituting
numerical value to L we can get MPL
(this method can be used only where
labour is perfectly divisible and L -> 0)
Alternatively where labour can increased
by at least one unit : MPL=TPL-TPL-1
Average productivity of labour APL can be
obtained by dividing production function by L
Computed table by increasing L is given in next
slide

No of
workers

Total
product
TPL

Marginal
product
MPL(TPL - tpl-1)

Average
product
APL

Stages of
production

24

24

24

Increasing

72

48

36

Returns -I

138

66

46

216

78

54

300

84

60

384

84

64

462

78

66

diminishing

528

66

66

Returns -II

576

48

64

10

600

24

60

11

594

-6

54

Negative

12

552

-42

46

Returns -III

 Application of law of diminishing

returns: this law will not be applicable
universally
This found to operate in agricultural
production than in industrial production
Despite of limitation of law if increasing
units of an input is applied to fixed
factors, the marginal returns to the
variable input decrease

 The law of diminishing returns and

business decisions: the table
identifies rational and irrational stages
of operation at stages I,II and III
Business managers can tell the number
of workers to be applied for the given
fixed inputs so that given all other
factors constant , output is maximum

 Long-term laws of production:

production with two variables:
We will discuss the relationship between
inputs and outputs under the condition that
both inputs, capital and labour are variable
In long-run supply of both the inputs is
supposed to be elastic and firms hire
larger quantities of both labour and capital
With larger employment of capital and
labour the scale of production increases

 The technological relationship between

changing scale of inputs and output is
explained under the laws of returns to scale
This law is explained through production
function and isoquant curve technique
Isoquant curves and their properties:
Iso means equal in greek and quantus means
quantity, therefore it is known as equal
product curve or production indifference
curve

 An isoquant curve can be defined as the

locus of points representing various
combinations of two inputs capital and
labour- yielding the same output
Thus an isoquant represents different input
combinations or input ratios that may be
used to produce a specified output
For movements along isoquant the level of
output remains constant and the input
ratio changes continuously

 So an isoquant curve is locus of points

representing various combinations of two
inputs-capital and labour- yielding the same
output
It includes all technically efficient methods of
producing a given level of output
Assumption:
There are two factors of production that is labour
(L) and capital (K)
Two inputs can substitute each other but at
diminishing rate and
The technology of production is given, the
production isoquants can be shown in fig

 Y
K4
K3

01
02

K2

03

K1

IQ1=100

CAPITAL (K)

IQ2

04

L1 L2 L3

L4

labour (L)

 In fig the curve IQ1 is an isoquant which

represents a fixed quantity of 100 units
of product Y
This quantity can be produced with a
number of labour-capital combinations
For instance, the points 01, 02, 03 and
04 on the isoquant IQ1, show four
different combinations of inputs K and L,
all yielding the same output 100 units

 The movement of 01 to 04 in the isoquant

indicate decreasing quantity of K and
increasing number of L
It implies substitution of labour for capital
such that all the input combinations yield
the same quantity of Y IQ1=100
Properties of isoquant:
Negatively sloped, indicating if one input is
reduced in quantity, the quantity of other
input has to be increase to maintain same
level of output

 Does not cross out the higher or

lower isoquants indicating different
quantities of output.
They need not be parallel. It indicates
that a given quantity of a commodity
can be produced with smaller as well
as larger input combinations

 Convex to origin. The degree of convexity of

curve indicates the relative ease or other wise,
with which one factor can be substituted for
the other when total output is kept constant .
This is called the marginal rate of technical
substitution. In this case it measures the reduction
in capital per unit of increase in labour
Different shapes of isoquants are linear isoquant
(perfect substitute K & L) , input-output isoquant (fixed
proportion)
, kinked isoquant
(K & L can be
combined only in fixed proportions also called linear programming
isoquants)

 Economies and diseconmies of

scale:
Constant return make sense
We would expect two similar workers using
identical machines to produce twice as
much as one worker using one machine
Similarly two identical plants employing
equal number of workers of equal skills to
produce double the output of a single plant
Nevertheless increasing and decreasing
returns to scale are possible

 Economies of scale: increasing returns arise

because:
1. As the scale of operation increases, a greater
division of labour and with large scale operation,
each worker can be assigned to perform only
repetitive task, thus workers become more
proficient
2. more specialised and productive machinery
can be used. Using a conveyor belt instead of fork
lift gives higher output
3. doubling size of pipe line and ship can deliver
higher output
4. lesser number of supervisors and lesser
inventory of spares add to economies of scale

 Diseconomies of scale:
1.as the scale of operation increases it becomes
difficult to manage and coordinate various
operations of the firm
2. Channel of communication become more
complex, no. of meetings, telephone bill, paper
work increase
3. difficult to ensure that managers directive
and guidelines properly carried out
Decreasing returns to scale refers to long-run
situations when all inputs are variable
Diminishing returns refers to short-run
situations where at least one input is fixed