Production Function.

Production Function specifies the maximum output

that can be produced with a given quantity of input.

It is defined for a given state of engineering and technical knowledge.

Production Function the relationship between

quantity of inputs used to make a good and the quantity of output of that good.

There are three important production concepts:

Total, Average & Marginal product.

Total product.

Total

product

or

total

physical

product

which

designates the total amount of output produced, in

physical unit.

Total product is simply the total output that is generated from the factors of production employed by a business. In most manufacturing industries such as motor vehicles, freezers and DVD players, it is straightforward to measure the volume of production from labor and capital inputs that are used. But in many service or knowledge-based industries, where much of the output is intangible or perhaps weightless we find it harder to measure productivity

Marginal product.

Marginal product is the change in total product when an additional unit of the variable factor of production is employed. For example marginal product would measure the change in output that comes from increasing the employment of labor by one person, or by adding one more machine to the production process in the short run. Marginal output of an input is the extra output produced by 1 additional unit of that input while other inputs are held constant.

Average product.

Average product is the total output divided by the

number of units of the variable factor of production

employed (e.g. output per worker employed or output per unit of capital employed).

Average product which equals total output divided by total units of input.

Example.
(1) Units of labor input. 0 1 2 3 4 5 (2) Total product. 0 2000 3000 3500 3800 3900 2000 1000 500 300 100 2000 1500 1167 950 780 (3) Marginal product. (4) Average product.

The table above shows the total product that can

be produced for different inputs of labor when other

inputs ( capital, land, etc.) and the state of technical knowledge are unchanged. From total product, we can derive important concepts of marginal and average products.

Let as assume the example with a firms production

function, the total product starts at zero for zero labor and then increases as additional units of labor are applied, reaching a maximum of 3500 units when 5 units of labor are used.

Once we know the total product, it is easy to derive an equally important concept, the Marginal product. Assume that we are holding land, machinery, and all

other inputs constant. Then labors marginal product

is the extra output obtained by adding 1 unit of labor. The third column of table calculates the marginal

The marginal product of labor starts at 2000 for the

first unit of labor and then falls to only 100 units for
the fifth unit.

The forth column of table shows the average product of labor as 2000 units per worker with one worker, 1500 units per worker with 2 workers, and

so forth.

Marginal product is derived from Total product.

Cont

In the above fig (a) shows the total product curve rising as additional inputs are added, holding other things constant. However, total product rises by smaller and smaller increments as additional units of labor are added (compare the increments of the first and the fifth worker). Fig (b) shows the declining steps of marginal product. Make sure you understand why each dark rectangle in (b) is equal to the equivalent dark rectangle in (a). The area in (b) under the marginal product curve (or the sum of the dark rectangles) adds up to the total product in (a).

Law of Diminishing Returns.

Using production functions, we can understand one of the most famous laws in all economics, the law of diminishing returns. Under the law of diminishing returns, a firm will get less and less extra output when it adds additional units of an input while holding other inputs fixed. In other words, the marginal product of each unit of input will decline as the amount of that input increases, holding all other inputs constant.

Cont..

The law of diminishing returns expresses a very basic relationship. As more of an input such labor is added to a fixed amount of land, machinery, and other inputs, the labor has less and less the other factors to work with. The land gets more crowded, the machinery is overworked, and marginal product of labor declines.

The law of diminishing returns expresses a very basic relationship. As more of an input such labor is added to a fixed amount of land, machinery, and other inputs, the labor has less and less the other factors to work with. The land gets more crowded, the machinery is overworked, and marginal product of labor declines. Table 6-1 illustrates the law of diminishing returns. Given fixed land and other inputs, we see there is zero total output of corn with zero inputs of labor. When we add our first unit of labor to same fixed amount of land, we observe that 2000 bushels of corn are produced.

In our next stage, with 2 units of labor and fixed land, output goes to 3000 bushels. Hence, second unit of labor adds only 1000 bushels of additional output. The third unit of labor has an even lower marginal product than does the second, and the fourth unit adds even less. Table 6-1 th illustrates the law of diminishing returns.
Figure 6-1 also illustrates the law of diminishing returns for labor. Here we see that the marginal product curve in (b) declines as labor inputs increase, which is the precise meaning of diminish returns. In Figure 6-1 (a), diminishing returns are seen as a concave or dome-shaped total prod curve.

Cont

What is true for labor is also true for any other input. We can interchange land and labor, n holding labor constant and varying land. We can calculate the marginal product of each input (land, machinery, water, fertilizer, etc.) , and the marginal product would apply to any output (wheat corn, steel, soybeans, and so forth). We would find that other inputs also tend to show the law diminishing returns.

Cont

We can also use the example of studying to illustrate the the law of diminishing returns. You might find that the first hour of studying on a given day is productive- you learn new laws and facts, insights and history. the second hour might find your wandering a bit, with less learned. The third hour might show that diminishing have set in with a vengeance, and by the next day the third hour is a blank in your memory. Does the law of diminishing suggest why the hours devoted to studying should be spread out rather than into the day before exams?

Diminishing Returns in corn production.

Cont

Agricultural researchers experimented with different doses of phosphorus fertilizer on two different plots to estimate the production function for corn in western Iowa. In conducting the experiment, they were careful to hold constant other things such as nitrogen fertilizer, water, and labor inputs. Because of variations in soils and microclimate, even the most careful scientist cannot prevent some random variation, which accounts for the jagged nature of the lines. If you fit a smooth curve to the data, you will see that the relationship displays diminishing returns for every dose and that marginal product becomes negative for a phosphate input of around 300.

Returns to Scale.

Diminishing returns and marginal products refer to the response of output to an increase of a when all other inputs are held constant. We saw that increasing labor while holding land would increase food output by ever-smaller increments. But sometimes we are interested in the effect of increasing all inputs. For example, what would happen to wheat production if land, labor, water, and other inputs were increased by the same proportion? Or what would happen to the production of tractors if the quantities of labor, computers, robots, steel, and factory space were all doubled? These questions refer to the returns to scale or the effects of scale increases of inputs on the quantity produced. Three important cases should be distinguished:

Constant returns to scale .

Constant returns to scale denote a case where a change in all inputs leads to a proportional change in output. For example, if labor, land, capital, and other inputs are doubled, then 1 constant returns to scale output would also double. Many handicraft industries (such as haircutting in America or handloom operation in a developing country) show constant returns.

Increasing returns to scale.

Increasing returns to scale (also called economies of scale) arise when an increase in all inputs leads to a more-than-proportional increase in the level of output. For example, an engineer planning a small-scale chemical plant will generally find that increasing the inputs of labor, capital, and materials by 10 percent will increase the total output by more than 10 percent. Engineering studies have determined that many manufacturing processes enjoy modestly increasing returns to scale for plants up to the largest size used today.

Decreasing returns to scale.

Decreasing returns to scale occur when a balanced increase of all inputs leads to a less proportional increase in total output. In many processes, scaling up may eventually reach a beyond which inefficiencies set in. These might arise because the costs of management or control become large. One case has occurred in electricity generation, where firms found that plants grew too large, risks of plant failure grew too large. Many productive activities involving natural resources, such as growing wine grapes or providing clean drinking water to a city, decreasing returns to scale.

Cont

Production shows increasing, decreasing, or constant returns to scale when a balanced increase in all inputs leads to a more-thanproportional, less-than-proportional, or justproportional increase in output.

Increasing returns to scale occur when the % change in output > % change in inputs. Decreasing returns to scale occur when the % change in output < % change in inputs. Constant returns to scale occur when the % change in output = % change in inputs.

Short run & Long run.

Production requires not only labor and land but also time. Pipelines cannot be built overnight, and once built they last for decades. Farmers cannot change crops in midseason. It often takes a decade construct, test, and commission a large power plant. Moreover, once capital equipment has been put in the concrete form of a giant automobile assembly plant, the capital cannot be economically dismantled and moved to another location or transferred to another use.

Cont

To account for the role of time in production and costs, we distinguish between two different time periods. We define the short run as a period in which firms can adjust production by changing variable factors such as materials and labor but cannot change fixed factors such as capital. The long run is a period sufficiently long that all factors including capital can be adjusted.

Cont

To understand these concepts more clearly, consider the way the production of steel might changes in demand. Say that Nippon Steel is operating its furnaces at 70 percent of capacity when an unexpected increase in the demand for steel occurs because of the need to rebuild from an earthquake in Japan or California. To adjust to the higher demand for steel, the firm can increase production by increasing worker overtime, hiring more workers, and operating its plants and machinery more intensively. The factors which are increased in the short run are called variable factors.

Cont

Suppose that the increase in steel demand persisted for an extended period of time, say, several years. Steel would examine its capital needs and decide that it should increase its productive capacity. More generally, it might examine all its fixed factors, those that cannot be changed in the short run because of physical conditions or legal contracts. The period of time over which all inputs, fixed and variable, can be adjusted is called the long run.

Cont

In the long run, Nippon might add new and more efficient production processes, install a rail link or new computerized control system, or build a plant in Mexico. when all factors can be adjusted, the total amount of steel will be higher and the level of efficiency can increase. Production requires time as well as conventional inputs like labor. We therefore distinguish between two different time periods in production and cost analysis. The short run is the period of time in which only some inputs, the variable inputs, can be adjusted. In the short run, fixed factors such as plant and equipment, cannot be fully modified or adjusted. The long run is the period in which all factors employed by the firm, including capital, can

how to produce?

Short run One variable input ( law of variable)

Long run

Two variable inputs

inputs (Isoquant analysis) Scale.)

All variable
( Returns to

Difference Between

Returns to Proportion & Returns to Scale.

Returns to Scale. Long run Production Function. All the factors are varied.

Returns to Proportion. Short run production function. Only one factor is varied and all the others are kept constant.

Factor proportions are changed.

Factors proportion are not changed. The Scales are changed.

Law does not apply when factors Law does not apply when factors must be used in a fixed must be used in a fixed proportion to produce a product. proportion to produce a product.

Production function with two variable inputs.

If both capital & labor are variable; a different set of analytical techniques is applied to determine the optimal input rates. There are twin methods to approach the problem of efficient resource allocation in production. They are firstly, output maximization to maximize the production for a given rupee outlay on labor and capital & secondly, cost minimization to minimize the rupee outlay on labor and capital necessary to produce a specified rate of output.

Cont
These are also known as problem of constrained optimization. In the first case fixed monetary outlay is constraint while in the second case its the specified rate of output to be produced. If only labor & capital are variable inputs then selection of optimal factor combinations will depend up on: 1. Technical possibilities of Factor Substitution (Isoquants), and 2. Prices of Factors of production ( Isocost Lines).

Isoquants.

An isoquant represents all those combinations of inputs, which are capable of producing the same level of output. Isoquants are also called equalproduct or iso-product or iso-product curves. Since an equal-product curve represents all those combinations of inputs, which yield an equal quantity of output, the producer is indifference between them. Therefore, another name for an isoquant is production indifference curve.

An isoquant is a graph that shows all the combinations of capital and labor that can be used to produce a given amount of output.

Properties of Isoquant Maps

There are an infinite number of combinations of labour and capital that can produce each level of output. Every point lies on some isoquant. The slope of an isoquant is equal to: - MPlabour / MPcapital = - MPL / MPK = K / L The slope of the isoquant is called the marginal rate of technical substitution which can be defined as the rate at which a firm can substitute capital for labour and hold output constant.

Isoquants Showing All Combinations of Capital and Labor That Can Be Used to Produce 50, 100, and 150 Units of Output (Figure 7A.1)

The Slope of an Isoquant Is Equal to the Ratio of MPL to MPK (Figure 7A.2)

Assumptions.

It is assumed that there are only two factors or

inputs of production.

It is that factors of production are divisible into small units and can be used in various proportions.

Technical conditions of production are given and it is not possible to change them at any point of time.

Properties of Isoquant.

Isoquants are negatively sloped. A higher isoquants represent a larger output. No two isoquants intersect or touch each other.

Isoquants are convex to the origin.

Iso-costs or Equal-Cost Lines.

Iso- cost line represents the price of factors. It shows various combinations of two factors, which the firm can buy with, given outlay.
An isocost is a graph that shows all the combinations of capital and labor available for a given cost.

Isocost Lines Showing the Combinations of Capital and Labor Available for $5, $6, and $7 (Figure 7A.3)

Isocost Line Showing All Combinations of Capital and Labor Available for $25 (Figure
7A.4)

The slope of an isocost line is equal to - PL / PK.

The simple way to draw an isocost is to calculate the endpoints on the line and connect them.

The Cost Minimizing Equilibrium Condition.

Slope of isoquant = - MPL / MPK Slope of isocost = - PL / PK

For cost minimization we set these equal and rearrange to obtain:

MPL / PL = MPK / PK

Finding the Least-Cost Combination of Capital and Labour to Produce 50 Units of Output (Figure 7A.5)
Profit-maximizing firms will minimize costs by producing their chosen level of output with the technology represented by the point at which the isoquant is tangent to an isocost line. Point A on this diagram

Minimizing Cost of Production for qx = 50, qx = 100, and qx = 150 (Figure 7A.6)

Plotting a series of costminimizing combinations of inputs - shown here as A, B and C - enables us to derive a cost curve.

A Cost Curve Showing the Minimum Cost of Producing Each Level of Output (Figure 7A.7)

Economies & Diseconomies of Scale.

Economies & diseconomies of scale determine also returns to scale. Increasing returns to scale operate till economies of scale greater than the diseconomies of scale , and returns to scale decrease when diseconomies are greater than the economies of scale. When economies and diseconomies are constant returns to scale are also constant. Kinds of economies & diseconomies of scale: 1. Internal economies & diseconomies of scale and 2. External economies & diseconomies of scale.

Economies of Scale.
Economies of Scale make it advantageous for each country to specialize in the production of only limited number of goods & services and to manufacture them in large quantities, partly for exports. Two types: (1)External economiescost per unit depends on the size of industry, not the size of the firm. (2) Internal economiescost per unit depends on the size of the individual firm.

Internal Economies.

We see that the returns to scale increase in the initial stage and after remaining constant for a while, they decrease. The question arises as to why we get increasing returns due to which cost falls and why after a certain point we get decreasing returns to scale due to which cost rises. The answer is initially a firm enjoys external economies of scale and beyond a certain limit it suffers internal diseconomies o f scale. Internal economies are of following main kinds:

Economies of Scale

The advantages of large scale production that result in lower unit costs (cost per unit) Economies of scale spreads total costs over a greater range of output The whole point about economies of scale is in the word 'scale'. Scale means big, large,

massive

; and as such gives us a clue to the nature of this topic .

The changing scale of production

Economies of Scale

Internal advantages that arise as a result of the growth of the firm

Technical Commercial Financial Managerial Risk Bearing

Internal = growth of the firm

Economies of Scale

External economies of scale the advantages firms can gain as a result of the growth of the industry normally associated with a particular area

Supply of skilled labour Reputation Local knowledge and skills Infrastructure Training facilities

External = growth of the INDUSTRY

Economies of Scale - Internal: Technical

Larger companies can afford bigger machines which may produce more efficiently and do more tasks More machines can mean less staff Machines can work 24/7 The larger the business the greater the number of tasks that a piece of equipment will have to do. Increased dimensions bigger containers can reduce average cost A local B&B industrial toastermay only use a few racks, where a hotel will t end to use all racks at once!

Technical economies of scale going large!

Dualite 6 slicer 190 7.99 4 slicer 950 can toast 1000 slices per hour!

Bulk Buying Economies

The larger the company the more it tends to buy in materials and components.

The larger the order the better the discounts and the less frequent deliveries also reduces delivery costs. Supplier just uses a larger box/lorry rather than sending in lots of small packages!

What profits can be made from bulk purchasing?

Motorola Razr V3i D&G Cellular Phone RRP: 504 Wholesale Price: 154 Min bulk purchase 100

Managerial Economies

The larger the company, the more specialised each manager can become.

Use of specialists accountants, marketing, lawyers, production, human resources, etc

In a small business, there is usually only one manager who has to do everything.
In a large business, there is a larger span of control, with specialist managers for each department.

Financial Economies of Scale

The smaller the business, the greater the risk for a bank to lend you money. The larger the business, the less of a risk due to experience, more products, greater diversification, better specialist accounting managers.

Large firms able to negotiate cheaper finance deals.

Economies of Scale
Risk Bearing Greater Diversification Markets across regions/countries Product ranges how R&D

Proctor & Gamble

Owns 250 different product ranges.

Increased Dimensions economies of scale.

Literally the benefits of large scale factories.

This is a 10bn Anchor butter factory!

Economies of Scale
Unit Cost Scale A 82p

The larger the output the lower the cost per unit!
Scale B

54p LRAC

MES

Output

Economies of scale Diagram

Diseconomies of scale

Diseconomies of Scale

The disadvantages of large scale production that can lead to increasing average costs

So what could cause costs to increase?

Causes of Diseconomies of scale

Problems of management too many managers to control & lots of salaries to pay! Maintaining effective communication especially internationally different languages

Co-ordinating activities often across the globe!

De-motivation and alienation of staff a very small person in a very BIG business..

Divorce of ownership and control staff/managers care about the company?

do

So whats the benefits of being small?

Brainstorm

Benefits of being small.

Managers know every member of staff

Managers are on the shop floor or deal with

customers every day Highly specialized products niche marketing where there might be inelastic demand!

Less of a threat to big firms who focus on mass markets.

Company vs. Firm.

A firm and a company are not separate entities

A firm is a type of a company.

The word firm was traditionally used for accounting and consulting companies and they are even today referred to as firms.

Firms are either sole proprietorship or partnership whereas company is registered and has shareholders.

Difference Between Company and Industry.

A company is a legal entity that gets incorporated under the Companies Act and is involved in manufacture and sale of products or services. A company is always a part of an industry which comprises many other companies that are involved in manufacture of similar products and services. Company is part whereas industry is whole.

Industry is always bigger than a company.

Company vs. Industry.

If you hear the name General Motors, what is the image that comes to your mind? Of course, the automobiles made by General Motors as they have become so popular all over the country. Now automobiles are made by many other organizations also as General Motors is a part of an industry that is involved in the manufacture of automobiles. It is clear then that it is a part and whole relationship. General Motors is a company that is a part of the automobile industry. However, some people still confuse between the terms company and industry. For such people, here is a brief explanation of the two terms.

Company.

Company is a business entity that is a body made up of individuals that are together to further the aims and objectives of the company. A company can take many forms. It is a legal entity that can take many forms such as a corporation, partnership, association, private limited or public limited company depending upon its registration and also its structure. A company is treated as an individual by the law which goes on in perpetuity irrespective of the death or insolvency of the owner. A company comes into existence after registration under the Companies Act, and once incorporated, has to pay taxes just an individual would on his income.

Industry.

Industry refers to a particular sector of economy that is either involved in manufacture of goods or providing services. An industry is the sum total of all the companies that are involved in one particular activity or a group of activities. For example, Revlon may be a cosmetic company making beauty products, but it is only a part of a huge cosmetic industry which has hundreds of companies manufacturing similar beauty products. Thus any industry is always bigger than a company or a group of companies.