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Production Analysis
Production: The transformation of inputs into output (good or service) through value addition that has utility to either producers or consumers.

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Production Function
A technical relation which relates the maximum quantity of output that can be produced from given amounts of various inputs. X = f ( L, K, R, S, V) It describes the laws of production that is the transformation of factor inputs into outputs at any particular time period. The production function includes all the technically efficient methods of production.

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X=f(L,K,R,S,v,y)

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Efficiency in the use of inputs (Labor, Capital, Land and Entrepreneurship) Technical Efficiency Occurs when it is not
possible to increase output without increasing inputs.

Economic Efficiency Occurs when a given

output is being produced at the lowest possible cost. Improvement of Technology is reflected in an upward shift in the Production Function. The same amount of input leads to a higher output.

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Improvement of Technology is reflected in an upward shift in the Production Function : The same amount of input leads to a higher output

Laws of Production

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The laws of production analyze the technically possible ways of increasing the level of production. Output may increase in various ways. In the short run output may be increased by using more of the variable factors while keeping other constant. This is referred to as Law of variable proportions. While in long run output expansion may be achieved by varying all factors and it is known as laws of returns to scale.

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Short Run Analysis Law of Diminishing Marginal Product

As additional units of a variable input are combined with a fixed input, at some point the additional output (i.e., marginal product) starts to diminish. Also known as the Law of Variable Proportions since it refers to the Short Run when all factors are kept fixed except one ( therefore the proportion in which factors are being employed keeps changing)

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Marginal Product of Labor (MPL)

The change in output resulting from employment of an additional unit of labor. MPL = X L If MP > 0, TP is rising If MP < 0, TP is falling TP is maximum when MP = 0

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Average Product of labor (APL)

Average change in output resulting from total product divided by total no. of labor units. APL = X / L If MP > AP, then AP is rising If MP < AP, then AP is falling MP = AP when AP is maximum

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Three Stages of Production

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Stage I Capital is Underutilized and Successive units of L add greater Amounts to TP Stage II Addition to TP due to increase in L continues to be positive but is falling with each unit Stage III Fixed Input capacity is reached and additional L causes output to decline

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Long Run Analysis

All inputs are variable Analysis is carried out with the help of Isoquants Isoquant : An Isoquant shows the various combinations of inputs (L & K) that the firm can use to produce a specific level of output, given the state of technology.

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A higher isoquant refers to a larger output, while a lower isoquant refers to a smaller output. Isoquant shape shows Diminishing Marginal Rate of Technical substitution. C shaped isoquants are common and imply imperfect substitutability

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In case the two inputs are imperfectly substitutable, the optimal combination of inputs depends on the degree of substitutability and on the relative prices of the inputs The degree of imperfection in substitutability is measured with marginal rate of technical substitution (MRTS): MRTS = (L/(K = - MPL / MPK

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Optimal Combination of Multiple Inputs

Isocost : If a firm uses only L & K, the total cost or expenditure of the firm can be represented by C = wL + rK Optimization problem : One can solve for the combination of inputs that either : Minimizes total cost subject to a given constraint on output OR Maximizes output subject to a given total cost constraint

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Isocost Curve and Optimal Combination of L and K

K The maximum output that can be achieved given the Cost Outlay is Q1 Q3

Q1 Q0

Q2

L Isocost and isoquant curve for inputs L and K

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Optimal input Combination Depends on the relative prices of inputs and the degree to which they can be substituted for each other MPL MPK = w r Represented by the point of tangency between Isocost and Isoquant

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Returns To Scale
Shows the output effect of increasing all inputs. 3 types of returns to scale : Constant returns to scale Increasing returns to scale Decreasing returns to scale

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If the quantity of all inputs used in the production is increased by a given proportion, we have Constant Returns to Scale if output increases in the same proportion; Increasing Returns to Scale if output increases by a greater proportion; and Decreasing Returns to Scale if output increases by a smaller proportion.

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Constant Returns to Scale

K

B 200Q

3 3

A 100Q 6

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Increasing returns to scale

K

C 300Q

A 100Q 3 6

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Decreasing Returns to Scale

K

D 150Q

A 100Q

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Reasons for Increasing Returns to Scale

Specialization of labor Indivisibilities of factors Managerial Economies Technologies that are cost effective at high levels of production generally have higher unit costs at lower levels of output

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Reasons for Decreasing Returns to Scale

Managerial inefficiency Exhaustible natural resources Increased bureaucratic Labor inefficiency Pressure on inputs market due to increasing demand Pressure on inputs prices due to bulk purchase

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Production with Two (or more) Outputs (Economies of Scope)

Economies of scope exist when the unit cost of producing two or more products/services jointly is lower than producing them separately, producing related products, and the products that are complementary. The average total cost of production decreases as a result of increasing the number of different goods produced