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APPENDIX!

4,

COST-OUTPUT

RELATIONS

A.4.1

A FUNCTIONAL RELATIONSHIP BETWEEN


COST AND OUTPUT LEVELS:

A Functional relationship exists between the co'st of


production and the output levels,

Cost function shows various

costs which will be incurred at alternative output levels:

Cost * f (output)

But the output level in turn, is a function of factor inputs


used:
Output f (inputs)

And the prices of the factor inputs used are termed


as the cost of producing a given level of output.

Thus at a

firm level, the cost purely deponds upon the two principal
factors: the'Character of the production process employed, and
the prices paid to different factor inputs.

Of these two, the

first decides the shape of the firm's cost function? whereas


the second ono determines the level'of cost.

Here, since the

firm is one of many others to demand for the factor inputs, it


cannot influence the prices of the concerned factors.

Instead

its output lovel is indirectly influenced by the prices it has


to pay to the factor-inputs.

And with the changes in its

output leval, there is a corresponding change in the total cost.


Thus cost is directly related with the output lavel.
Cost function expresses the relation between the output
and the corresponding cost.

Hera, the cost is expressed as a

A.452

function op output.

On the other hand, cost equation exoracsss

cost in terms of input levels and input pricss.

A cost-output relation can bs statad in a simple


form ass
TC = a * &Q

(l)

where TC is the total cost* C is the quantity cf output, a is


the intercept (a constant} and b is a parameter.
A number of special cost relations, which srs also
functions of the output levels, can bo derived from (l}
For example,
ATC

a + bQ
Q

&

(2)

AFC e a
Q
AVC ss bQ
Q

(3)

(4)

s= b

where ATC i3 average total cost, fifC is average fixed cost, At'C
is average variable coat end a sb and Q are as specified above.

Total cost, as referred to above


of output.

is a linear function

And ATC, AVC and RC are second degree curves.

They

first decline and than increase with increase in output (q ).


For example, Cost Function in cubic form can bo written as
*?

*7

TC

sa a + btj +

cQ~

+ dQ

under certain economic limitations.

(s)

A 4 *3

When Q

soma fixed cost.

0,
TC

TC will be positive nines there is al.uay3

a s and a

0.
/d o

TC increases as Q increases; hones DC yjQJ is always


COSitlWO.

d(TC)
dQ

2eU + 3d5

On fcho b a s i s c s o t h / i

c c rd lb J c r iO ., ihf- n i " - o

(5 )

fC

will occur where 't

d(WC)

- o

dO
i
0. 2c '5* SdU

'
~

Tha second order condition s

fid >

d ir

Tha second order condition is fulfilled if d > 0 and MC is


minimum when

OR

6dQ

2c

is 2c
6d

~c
3d

iS~'3)

Since Q can newer ba negative, charsfore to make -c,

always positive quantity0 c should always on s negative cuan;:.ty


b < C

{'o*

d > 0

from second ardor cordiricnj

a h

The. absolute value of PIC will bej


PIC = b * 2c

rx =

(\ $-U)/ +

3d [

-I 1

{6s5}

oa

'
\v

3db - c?
bd
which should always be positive
9
Hare s 3cb - c"> C
(since c>
>
OR
3db > c~
OR

c <

<e. 5

i.

3db

Th u s , under Ihs normal economic Unitec: ens, the uosf ?Icisnts


a, b, c, and d in the given cubic total cost ^unction should be
restricted as under %
(i)

a, c and d > 0

(ii)

b < 0

and (iii)
A4.1(1}

c2 < 3db
Statistical Cost function;
y

The cost functions in general

**

o)

where Y is the total cost, X,, XX

=. . '<re -overeI exp .Isr->c

'/

factors and u is error tarsi, reflecting the stochastic nature


of the relationshipc

1/

Dohncton D,

Along with the parameters, it cur; oa

s Statistical Cc.ec Analysis, (FicGrow-Hiij 3ook

Co. Inc., New York, 1960), pp531~34,

ft. 455

written S3 *

* b1 Xit + b2 X2t +

+ bR XKt * ut

(1 .2 )

(t 1,2, . . . n)

whar Y^ represents the cost in tins i , X ^ rap re sent 3 the rats?


of output in tine t end other Xss represent squared or cubed
terms In otjcpui, and tn*j rena?.jnq X'1s tn03o fscfcci- lu"ilc~
influence costa but whose affects is to be estimated and then
constant for examining the not relationship DetacQn costs

~>c

output.

Three major hypotheses about short-run coat-output


variation may be characterised by the inclusion of first 3
second? and third-degree terms in output among the explanatory
variables.
Sines a livjear total cost function is i-neanpatibie
perfect competition assumptions, a cost function as a sscona
dagrsa polynomial in output is used as s
C iK 3 't h X t h X** -h *5
t
'
1 t
2 t
~t

r<)

7
1 t~9

whera 3 C,

total

cocc

in oeyioc t

ss output in period t

error term

implies that cost may vary in

random fashion from

pariod to period about the expected value given hy this ocly

A . 6 s6

I f ?.

' t-1

=s market price expected to rule in period h and


' j h a f O

market price in period (t-1) a

t~1

tha output X, is selected at uhich the marginal cost


t

FiC =

2bXt

(2.4;

and are eaual to the oxoected price (P^),

This means that the

planned output the firm may decide to have ic

2b2

2b_

Statistical cost function examines the nature of tha


intra-firm rgjationahio between costs and output.

Tha two major

1/
findings

of the research in this field are: !'(s) that short-run

total costs are linearly related to output - hence HC are sub


stantially constant o vsr a wide range of output; and (b) that, long-run
AC tends to decline with increase in the scale of output quickly at
first and then more slowly, but with little or no indication c,f
the expected rise at high output lavsis."
Tha cost function is stochastic.

No statistics! analysis

can prove that a certain cost-output relationship is the true one;

1/

uohnston, 3 .1 "Statistical Cost Functions! A Reappraisal",


The Raviaw of Economics and Statistics, Vol,40, No.4,

1958 r p p !3 3 9 -3 5 0 .
2/

Rugglos, R.s "The Concept of linear Total Cost output


Regression", American Economic Review. Vol.31, No.
1941, ppS332-335.

A.4S7

it provides although, a procedure to reject/accept a


hypothesis.

The hypothesis of a linear total cost function

has not been rejected by a large number of studies.

Besides,

no statistically significant improvement on the linear


hypothesis is mads by' the inclusion of second or higher degree
terms in output.

Variations in the cost influence the output levels.


These variations are characterised by the reference period.
Hsnce, it is useful to differentiate bstwsen tho short run and
the long run cost behaviours.

The built-in characteristics

of tha short-run and the long-run are well known.


Of the known resource inputs that aro going into tho
production process, some are fixed and some aro variable inputs
in the short run, and hence the consequent cost structure
assumes certain type of shapes in the 3hori run.

On the other

hand, almost all the resource inputs being variable in the long
run, ths resulting cost takas an altogether a different
shape.

Such differences in the cost curves start a convenient

approach to examine the cost behaviour at the macro level


(at the state level) industry groups teking a firm level cost
and output details.

A,4i8

A42

SHORT-RUN COST-OUTPUT RELATIONSHIP:

The total cost in the shorttun has the faaturas


differsnt to that in the long run.

In the short run. total

fixed cost, total variable cost end total cost concepts ara
worth examining. Total fixed cost is
n
TFC

P,X,

(1

uhsra P. in the pries of the specified fixed incut, X. Is

'

the quantity of the specified fixed incut, and n is the number


of various kinds of fixed input'sFixed costs do not vary with the change in the
output level.

Set variable costs vary with the cnangps in the

output level.

Certain inputs arc necessary only if the cutput

is to be increased; hence total variable costs increase with


the increase in the output level.
Thus, total variable coat is
m

ivc * ^

y:,

(2)

where P, is the price of a specified variable input, Xj is tho

quantity of a specified variable input, and m is ths number of


various kinds of variable inputs.

TVC is zero whan output is

zero, but TFC > 0 when output is zero.


Tha total cost la ths sum of the total fixed cost and
total variable cost.
TC x TFC + TUC

CO

A4f9

A'c assra o-jtDi

Four major types of unit cost can bs derived from the


total cost concept.

They ars? cvcpag* fixed cost* everagp

variable cast* average total cost and marginal cost


last on is very much important.

MC

The*

It can be expressed as

TVS

{&.}

A Q
It is of central interest for ths fact that it reflects those
costs which could bs controlled in the short-run,,

Ths dsfini

tions of AFC, AVC and MC era used while a^amining ths cost
behaviour both at the micro and macro levels*.
Those cost-output relations can be examined in ths

context o? the following four types of short-run production


functions.
*>

(1 ) Q ra a

bx * cx

(incraasirig returns to
variable inputs)

(2)

Q m a + fex

(constant returns to
variable inputs)

(3)

Q s 0 + fex - cx

(decreasing returno to
variable inputs)

(4) Q

a + bx -5* cx

dx

(increasing and aecroeoing


returns to variable inputa

whera8
Q is the output level0 x is the variable input and a is
ths constant

A.4*10

A.4.2(l) Cost-output relation under increasing


returns to variable Inputs?

With increasing returns to variable input, each


additional unit of variable input increases the total output
than does the previous unit.

Thus

*?

when

and

(1 .

Q = a + bK + cx
PiP a b

2cx

A? b

ex

Hence f
TC a + bQ ~ oQ^
TFC a a
TVC a bQ - cQ*

Since firm's fixed inputs do not change in the short


run, a constant amount of cost results, irrespective of any
change in ths prices of the fixed input. Thus, 1TC hors,
includes, as referred to above, both explicit and implicit
costo.

It doss not vary with ths changing output level.


TVC is continuously increasing with the increasing

output levels.

Given the pries of the variable input., whon

additional variable inputs are added along with the fixed


inputs, the output doss increase, as pointed out above, but
with tha increasing TVC.

The output increases with grontsr

and greater increments when ths variable inputs arc added or,
gradually and so is the resulting TVC.

But there is

difference in the rates of increase of output levels (a;

A.4S11

and

that of TVC.

When Q increases at an increasing rate with

the corresponding addition of the variable inputs, the result


ing TVC increases at a decreasing rate.

Thus?

TVC bQ - cQ2

(1.4)

T V C is zero, when Q = 0? hones TVC function starts

1/
from the origin.
Given TC = TFC + TVC
the total cost function can be written a s 5

TC - a + bQ - cQ2

<1.2)

uheres a represents TFC and


(bQ - cQ2 ) represents TVC

The nature and behaviour of AVC can be deduced From


TVC function ass
AVC - ~ ~ = ~ r - ~

a(b - cQ) b - cQ

(1.5)

The significant point here, to note, is that the unit


variable cost falls with the increase in the output

(q ) under

the conditions of increasing returns to variable input.

1/

Q = bx + cxl is the production function


TVC = bQ - cG is the TVC function

<1}
(2)

Hers these two equations have similar form, but-t'no


values of b and c in the production function (l) ars
different than the values of b and c in the TVC
function

(2).

}
,his is bsc&use the reJationohio between AVC and Yvs'
production function
AVC

KS

P yy

, ]
1 _!

VI

<> ;
i

wH o jc s *

P. is tho priea of the variable input and AP_ is

Vi

VI

ths averags productivity of the variable input.

Under the

conditions of increasing rstums tc variable input, ths AP.


VI
rises with every increase of variable input.

And with the

increase in APy_, AVC falls if the PyT does not change.

The ATC function can be derived by diviriir-o the TC


function by Q as *
ATC ! a - t J & c s !

| + b - cQ

(1,6)

Alternatively ATC function can be derived as

ATC a AFC * AVC


*

ATC s ~ + b - CQ
u

(1.6)

whareS

and

AFC a ~

(1,7)

AVC a b - cQ

(l.5)

as referred to above.
There is a asympototic relationship between AVC and
ATC.

It is not only unique to cost behaviour under the

condition

A.4*13

of increasing returns to variable inputs, but rpthar ;.a o ge;y?r.and necessary trait for all the types of production and cost

1/
situations.

The marginal cost (MC) function can bs obtained by


differentiating either* the TC or the TVA function with Q as

and

TC a + oD - cO2

(l.2)

TVC bQ - cQ2

0.4)

nc

I
dQ

2JVC

_ b _ 2c Q

(1.3)

dQ

The MC function is thus, linear.

ThB MC curve is downward

sloping, which indicates the rising marginal product of


successive units of variable input. With the increasing MP
and Pyj remaining constant, MC must necessarily Fall.

A,4.2(2) Cost-output relation under constant


returns to variable incuts

With the constant returns to variable input, each


additional unit of variable inputs adds the same amount to
total output as tho previous one. Tnis means that output,
increases at a constant rate and the corresponding production
function is linear.

1/

Under this circumstance, both MP and AP

Thompson, Or. Arthur, As Economics of the Firm* Theory


and Practice, (Prentice-Hall, Inc., Englewood Cliffs,
Mew Oorsey, 1973), p.273.

A* A ? 1 &

of v a r i a b l e i n p u t a r e
input,

tha same

for e v e r y

unit of

variable

When

0 s= a + b x

and where

a -

(2,l)

0 ? the v a r i a b l e input

PIP = 5 ,

and

a n d b is c o n s t a n t

has its

AP a b

which

is scual

to t h e s l o p e o f

the production

function.

T F C is not e f f e c t e d by
i n p u t s a n d Q.

the r i i a t i o n r h i p

between variable

Here;

T F C => a

TVC
production
to a unit

(2.2)

function

function,
pries

is t i e d up w i t h t h a n a t u r e o f the
TVC rises

by a f i x e d a m o u n t

(P.(T) o f the v a r i a b l e i n p u t .
Vi

is l i n e a r a n d b e g i n s

from t h e c r r c l n ;

equivalent

This means TVC

hence

T V C = bQ

(2.3)

B o t h T F C and T V C put

t o g e t h e r g i v e T C f u n c t i o n as;

T C <= T F C + T V C
T C = a + bQ

Tho

(2.4)

s h a p e s o f T C and T V C are

be s e p a r a t e d
ftt Q =

identical.

TC a n d T f C c u r v e s

by a c o n s t a n t v e r t i c a l d i s t a n c e e a u s l

can

to T FC.

0,, T V C = 0 and T C = TFC,

AFC doorcases continuously with Q increasing.


AFC a

TFC _ a
Q
Q

(2.5)

rvc _ bQ

(2.6 >

and s i m i l a r l y :
AV C

"

~Q

Ao4315

This means that AVC is a constant value.

And

graphically AVC here* is a horizontal line.


And, ATC under the condition of constant returns
to variable inputs is
ATC = T C = a + bQ

Q
Here, ~

&

+ b

(2.?)

is AFC and b is AVC,- which again shows the

equation ofs
ATC = AFC + AVC.
ATC curve is asymptotic to the horizontal AVC curve and
decreases throughout.

F!C being t h e f i r s t d e r i v a t i v e o f TC f u n c t i o n (os


TVC f u n c t i o n ) i s ?
NC **

dTC
dTVC
zzr
- 'JdQ
TA
dQ

* b

(2.8)

fib e rs b i s a c o n s t a n t .
Constant MC and AVC and gradually declining ATC are
the common features of

number of production processes over

the normal range of output.

A .4 . 2 ( 3 ) Cost-output relation under decreasing


returns to variable inputs^
With the decreasing returns to variable input, MP of
variable input declines throughout the output (Q) range.

Each

additional unit of variable input added to the available fixed


input adds less to total output then the previous unit.
increases with a decreasing''rate.

When
(3<>1}

Q - a + fax ex'
Both MP and AP of the variable input are down sloping,
TFC is a horizontal line as usual, hence
7FC = a
where

(3*2)

is s constant.
TFi. close not vary uith chs ruontiiy- oi" output iQi,
Since each additional unit of variable input adds

a cmailer increment in Q? TVC rises witn every additional unit


of variable inputs combined with the available fixed input.
The MP of variable input dsclinss gradually - makes Q to rise
even tnors slowly, while Tl!C increases steadily, at an
incroc3ing rata.
TVC ss bQ + cQ

{3,3}

and he nc e s
/\ 1w

TC = a + bQ + el*

it

'C increases at an increasing rats.


AFC, as usual, is a decreasing function,
asymptotic to the horizontal axis.
af;

TFC
Q~

anc

AWC

TVC

is

Its scuation io

a
~

:Q -t t:Q
3

~ b J- cU

This moans that under the condition of decreasing returns to


variable inputs P M C rises with every increase in C .

A,4*17 '

ATC b

TC

+ bQ + cQ

a + b -5- cQ

(Z*7)

whare

represents AfC agd (b + cQ) represents AVC.

Sine .

AFC

( S. ) dscsaasss continuously with tha increasing

Q the

AVC

Cr-> b

4A,

oQ; rises continuously.

Thus increasing

or deecsasing of ATC rests an the decrease of AFC relative to


thg increase of AVC when Q Increases.

But upto a certain

level of oufcoufc,, the decline in AfC is exactly offset by the


increase in AVC.

Qayond this 3aval* inerssso is. AVC overrides

the decrease in AFC.

find this results into an increase in AfC,

The ATC curve turns upwards


With the production function showing decreasing returns
to variable inputs PIC function is *

TC o bQ -t cQ2

l3o4)

dTt
MC J q = b -v- 2cQ

,
|3.8y

There is an increasing aspect of ilC.

These cost functions do not typify ths entire output


range for many production processes, although thoy are typical
of production and cost behaviour at near capacity levels of
output.

Bara HC, AUC, and ATC rise sharply.

;3 .>4,2 (4 } Cfist-Durou,. ro i.-itin -! usd,.; 1r.~

no

id dsereasinc reborns to rar iable, inou'1s,'-

Thu r-<xnicti.'-. rune's?on inc:orpo^V:tif;,: In c :

n>vj

d ^ c r e a s i n ^ r e t u r n s t o v a r i a b l e i n p u t* p r o y i n o e u ^ o - u - i a l ?': !
o f t h e p ro d u c tio n nrtri coe i ta e rav icu rs found X''> t b s f i r s t t h r u s
ty p o s o f j?" oriu'Jtiori 'Jur>oiionr ,,
2 " a + &x -4 e .,2
uhero 6 i a th e o u tp u t,
in p u ts .

Kor:;

...4?
5;

r e c r e a n t s th a u n i t s of v a t i c

I t nSotis t h a t Ih sS - :l i'-Cr-M- i n - *'.> uy; i tT y,y-

in p u tc 2.r; th e beg in n in g and dscrciooinr r n tu rn c feu t'.sr ssis>;


ssfc in*

H3X'0g G2 ".v'-tUS.1.0
1f

T!

TVC f u n c ti o n i n c l u d a s hare both in c r e a sin g and ciacreae--

in g r e t u r n s t o v a r i a b l e i r . p u t a .

Tha TVC curve incrnac-jof' s i c.

decreasing sain,, oysr tbs Usings of

ybor-a inssoacl-'.x rs'etjrnf-

t o v a r i a b l e i n p u t s p r e v a i l , uheras i t ipevBiusnz- a t n r- in c rc e o !n g
r s t o o u s r t h e rang o f Q yhore d e c re a s in g r e t u r n s t o y c r i o b l c
in p u to CDH?flto

ha a n p la n a tio n of the sb&rjp o f th.i TVC -vr.

rests with fch diminishing rasrginral returnE-

7ha equation uf

TVC i
TVC bQ - acT -> dST

;?i,3;

1C varies precisely at the seaa rat a does TVC,


TC os a t bQ - o? * dS**

Khar a

e p re e e n ts TTC and- (fcQ

a t each v e lu a o f Cl

\<o4;

oO

. ciQ""1} rcpvoPHV. r- VC

The behaviour of AVC its t

JC
AVC

lQ - sq2 * dCT

b cQ + dQ

(4S)

AVC c-jry o t!e c iir> a " t r l t i ^ i i y t maci-'K- o .nj.rdf'U.T; ;?nd ';r.er:


increases.

Thus. AVC curve is U shaped.

ATC can be c a l c u l a t e d by d i v i d i n g TC by Q

'u

g-~-

fta

+ b - cQ + dQ2

ATC ~

(4*6)

Hst >*
^C

n e f*

flFC T ~

&
q

if

Y)

ATC ourva is asymptotic to the AVC curve and is alee li chapotl.


Howevero the minimum point of fchs ATC curve io at n larger
volume of output than ie the minimum point of the AVC curve.

This is because ATC continues to fall beyond the output where


AVC is minimum.

The continuous declines of AFC ;ncco than off.spi

ttle smaller incrassess ir> AVC.

But with tha increasing amount

of Qj the increase in AVC overrides the decrease in AFC.


this makes ATC to turn upward.

And

The firm seams to oporatt* -tv:n

efficiently and economically at the sdrtimuss point on ATC

irs

tha short-run.

RC can bo darlved from TC m i

nc s

dTC
dQ

dTVC

dQ

* b - 2cQ t 3dq2

(4.8'.'

A, ^20

(iC curve is here U-ohaperi.


raust ba decliningo

So long as F*iP is rising, MC

Under ths assumption of

constant

price for the \,aCiabJs input, the increasing ossurns tc


variable inputs results in declining MC and vice-varsa.
From the foregoing outline of cost behaviour under
four different sets of production functions ~ sash one untiei
particular type of returns tc variable inputs the following
generalizations could be mads :

(1)

AFC curve is a rectangular hyperbola irrospactivs


of different shapes of othar cost curves0

It

declines mono torsicall/o


(2)

PIC curve passes through the minimum

points of AUC

and ATC curves.


(3)

FiC reaches its nininura before fi'JC and ATS and At/C
reaches Its minimum before ATC,

A.4.3

LONG RUN CQST-OUTPJJf RCIATX0NSH2PS

In ths long run ths tats! cost is oxpresosd as a


function of output level ond plant sirs t

C-

p Cq!k}-S-X(k)

whsre k shows the size of thG plant

(l)
the greater the value

of k the greater ths size of the plant.

In short-run5'ths

entrepreneur has to optimally utilize the plant of thy existin


size.

Against this, he is free to alter the size of his plant

in the long run..

And the shapes of the production and cost


1/

functions depend upon Kls plant size.

The above function gives the minimum cost of producing

each output level with the facility to vary the size of olento
Thus such a clan'c s i r e i s s e l e c t e d vHsr t ^ s TC

pinimun

Th

lonq~run cost curve; 9nvlr>ps Quits a number of short-run


cost

c u rv e s .

Tile minimum AC is attained ct the 's o t s plant r,i& on


ths minimum TC is producing that cutout level#
Ths long-run Mu is 1hs rate cf change of TC assuming
that ell costa are variable*

Thus* sows portion cf chert''yn

MC curve lies below the long-run MC curve*

Hence- the long-run

MC curve can be defined as the locus of thosa points on ths


uhort-run fiC curves which correspond is Inc. optimum plant sizs
for each output*
There is a ganerel acceptability cf ths o 'o sa rva h io r>
that given factor prices( .'long run aver~-.es
for low ranges of output*

ocvcg

( LKC) fallr

Here economies cf scale arise due

first to ths easy handling of largo quantities of factor-inputs


initially., second to ths fact cf spreading of flKod cost, risk

and reduction of costs of uncertainty ,

3/

2/

and third ic the axis-cerict-

Henderson 3.S anci R*# Quandts Micro oconrcr.io Thapry.-'


A Mathematical Approach t.McGraw r.ill Back C%s, ttw Vc,;k.,
1971p p.75*
U!hitins T .Mo and II.H. Prestons"Ra.ndon Variations,
Risk and Returns to Scsle'% puarterly Journal of Economics
Vol.68 , 1954, pps5C3**512o

of Indivisibility in labour and capital equipment.

Certainly

LAG declines first kith sirs, but there -s hardly any cqresnnmh
or. ii.f. shape wit-h cutpwt ir.rrsasi ng beyond a certain levrl,
Robinson, however strongly contends the rising aspects of LAC

if
goes or* incte3$i'<9o

as outpc

ry

Tnio contention has bnen strcnol

et Ibird r l oy Klora^cc on Vj ground that it in not sppit'i csily


tested on a widB scale.

"here are two main ccnciunirr>j! of empirical nose


3/
functions
(a)

long-run average ccsz curvp (LAC) is t-shespeti and

net U-nhapod.
(b)

short-run marginal cost (MC) is constant.

Thn first corseiusion seemc tc bo valid ers the ground


of technological consideration.

Tha t scent development in tha

production technology helps to achieve an increasing output


Level p.v3n yhilo keeping th-' v s r i o f . c

ki!.r.v'' .:-'l:i

Tho firm can .


i c m produce more output kith;
,
tnaraorlssSj, ths same minimum cost as before.
Ths rising part

manageable bounds.

3/

Robinson, E.A.G. x Ths Structure of Competitive) Industry,


(Cambridge, 193S).

2/

Florence P.U.S.s The Logic of British and American


Industry, (tendon, 1953)

3/

Walters, A .A .3"Procustion and Cosc Functions 3 in Co incest


Survey, aconoreetrisa< 1*01.31, No, 1-2, 1933, p.46.

4/

Sandesara 3 .C.s"Economies of Scale - Some NotesH0


ftrtha Vikas, Vo1.2, 1975.

A-4S23

cost
*?V'C C3
itf s n

c u rv e .
o f f c ? r.
ic

e ra

D e s p ite

th is .

to

o ff

chop

sees j t'-t

la s t

s o m e tjL n o a

t;ha

rjs io o

&f> i

C' 1,0 n ' t

9 th e
pc> r i

1s t

firm

has

o f" i t f !

to

cost

m ake
r. u ' . ' v c

o p c D a v e : i o n .

Regarding the second conclusion that short-run DC


is c c n a t a r t ; m e n t i o n may be fardo o' s-cnte i n H i u j
'if

studies.

lS'I

in d u stf'

r.

Andraus supported khs hyoothssls o* s

constant over aide range of output through making intensive

2/
study of business enterprisan0

siatsnt

uo'T.asort also found it con-

11/
with a large body e? empirical 8uider.ee.

T?.o

empirical evidence in favour of constant marginal cost is not

Cfohnstars,
Industry Study "ffiuiiiplo P r o d u c t - using
tintsseries data short run cost curve (1960)*
(Statistical Cost Analysis).
Dear., 3s Industry Study! 5Furniture*
using tic;
series data short run cost curve (194Hi
("Statistical Determination of coats with special
Reference to Marginal costs" Studies in Suctip^r.
Administration, Vol.7, 1935).
Industry Study Hosiery" using time ssrioc.
data Short run cost curve (1941)
(Statistical Cost Functions of & Hosiery Kill5 >
(Studies in Business Administrationt Voi.14, 1S41).
-j Industry Study *Departmental Stoca using tints "
series data - short run scat curve (1942)
- (Department Store cost Functions8 Studiaa In tlatbr
matical Economics and Econometrics (sd 0 <orton).pp 2 2 2 -2 5 4 5" 1 3 4 2 )7 "

Vntema, T .0. i Industry Study fSteel1 using timeseries


data ~* short run cost curve - (lS40)
(Stao.I Pricae,. Volume end Costs" Li.S Staei Corp.j,
Tsmp. Mato Eso. Paparo. lfol,1s pp -223-322, 'PAG*.
Andrews, P.U.S.s Manufacturing Business, (London, 1949)

If

Dohnston, 3 .s Ibid.

30

overwhelming.

Thors were ogrs other studies made

by

Ezakiol

and biylie, Nordin, Ehrke ate., which revealed marginal cost


sit her declining or ircrsasinc 0

'IpJsss ace moro empirical

evidence is coming forth, the constancy of marginal cost hao to


bs interpreted as a deviation from the established theoritiecl
concept of declining MC in tho beginning sr.d rising

on

as output goes on increasing.

Unfortunatelys very limited work a n the coot behaviour


analysis of Indian industries could be cited,

However c mention

may be made, here, of the few studies of Cost functions of Indian


2 / 3 / 4 /
Industry may by Guots, Alagh, Gupta, ... An average cost function
of twenty-nine manufacturing industries, using a time-serins

1/

Ezekiel,
and KH Wylie? Industry Groups 11Steal* =using time-series data short run cost curve,-.(]$4-i}
{"Cost curyea for Steel Production' journal of
Political Economy, Vo.!046, 19 40, pp ?77-32lT$
'Cost Functions for the Steel Industry" Journal of
American Statistical Associat i o n , Uol.36, 1941,
pps91-99.
Nordin, 3 A. .Industry Groups 5 Light Plant8 using timeseries data short run cost curve (1947), ('Nets
on a light Plant's Cost curves' Econometrics, Vol.15,
1947, pp. 231-235).
Ehrks, K.S Industry Group8 'Cement' using time-sarieo
data - short run cost curve (1933), (Oje Ufagyzsupung
in der Zementindustrie, 1858-1913, Jena r 1933}.

% [

Gupta V.K.s Cost' functions. Concentration, and Barriaars


to entry in Twenty-Nine Manufacturing Industries of India0 ,
The Journal of Industrial Economics, Vol.17, N o .1, 1958.

3/

Alagh, V.K.s "industrial Planning: Past Experience and Future


Tasks'*,Economic and Political' Weekly, August ly69, pp:M-107-lll.

4/

Gupta, G.S.s "Economies of Scale in Cement Industry", Economic


and Political Weekly. Vol.X, No.13, March 1975 pp.551-556

A.4S25

details cf total cost and output Tor the psrioc! ISSA-IB. hsvs
been estimated by Gupta,, For the industrywis plants belonging
'jfjmbst

to each size-group
emolcyadj total rest and oubp

were, calculated and than average

cost par rupee of output was worked out for estimating the cost
functions,,

A curvilinear regression aquation was fitted siding

mean cost-size observations for diffsrnnt size croupe in each


industry as 3

where Y is tha average cost and x is the size cf tha plant.


Davis has used this rvps of aquation while testing the

2/

hypothesis about the nature of cost output relationship.

The shapes of the cost curve whether U-shapsd or L-shaped ars


empirically verified. Gupta found U-shaped long-run overage

2/
cost. curves in only fivs inaustrisa
twsnty~nin3 industries.

cut o' n s a ^ - j a of

The L-shapao cost curves were observed

1/
among as many as eighteen cf :nssa industries
revealed a slightly rising leg of the L,

and three of them

At the and ha, however_

2/

Davis H . T The Theory of Econometrics, (Priricipia Press,,


Bloomington, Ind., 1941), p, 125.

2/

industries weras starch, machines, cement, cicilleries


and breweries, and rice rr.j 13 ioo

3/

industries wsrsi seuingmaohlnad, fruit and vegetable


processing, sugar, electric lamps, electric fans, soap,
woollen textiles, bicyciest paoer and paper board,
ceramics, biscuit-rasklngt plywood and tea-chests, vegetable
oils (edible), glsas and glassuara, tanning, wheat
flour, cotton textiles and general and alectriGai sngineprir
Ths first three of these eighteen industries had a rising
leg of L-shaped average cost curves.

A4?2S

contends that fchs sxlstencg of L-shaped long-run average cost


curves (LflC) in some industries does not rule out totally tbs
possibility of having U-shaped long-run average cost curves
among cults a large number of other induatriaec.

APPENDIX
5. TECHNOLOGICAL RELATIONS
SPATIAL DIMENSIONS

A.5

COBB-DOUGLAS PRODUCTION FUNCTION:

Cobb-Douglas production function in the two-factor cess


is:
X

Ah^ l /

sU

(1)

where X stands for the net value added by manufacture, K for the
capital and L for the labour (number of technical and non-technical
workers of all categories including supervisory, and managerial

j/
catecory) employed;

A is the intercept, o{ and

if

/2> are positive

constants, and u is the error term.

It shows the production technology existing among the


industry groups, and does not embody any technological progress.
It is homogeneous of degree

oi + jb , where Ot and j$

measure

1/

Cobb-Douglas production function can be specified with any


number of factor-inputs used in the production. Normally
the factor-inputs used in production are grouped together
under some distinct categories of inputs like capital (K),
Labour (L), fuel and power (R^) and other materials
There are strong relationships between K,L, R and R^.
None is independent of one another. However, the first
two primary inputs K and L are usually retained in the
final estimation of this production function.

2/

Bronfsnbrenner, M. and P.H. Douglas s ''Cross-Section studies


in the Cobb-Douglas Function", Journal of Political Economy,
V/ol.47, December, 1939, pp:?61-?8S. Also see : C.U.Cobb
and Paul H. Douglass "A Theory of Production'1 American
Economic Review, Suppl. l/ol.18, 1928, pp.139-165.

A.5:2

.1/

cross elasticities

of response of production (here X) with respect

to K and L respectively.

It has constant elasticities of output

variation wish rcsDsct to (w.r.t.) capital or labour input.


relationship is loo-linear,

This

further, it is implicit in such a

formulation that the considered factor inputs must be greater than


rero; in the absence of which the corresponding output levels cannot
bs defined mathematically.
production process.

One per cent increase in say labour, keeping

capital constant, adds p


case for capital.

Thus both of them are necessary to the

per cent tc output and similar is the

Hence, with the ore per cent increase each of

2/
both K and L leads c.utout to increase by ( ot + j2 ) par cant.

The non-linear function is transformed into n linear


function by using the logarithmic transformation as:

Log X * Log A + o< Log K * 0 Log L + u

(2)

cX. and p refer to gross elasticity of output w.r.t. K and L


for the fact that they also account for the output elasticities
and R0 , Hoxe R_, end Fln
w.r.t. other factor-inputs c.uch as
form a group of intermedial e i n p u t s , U'wch are automotic/aiy
dropped out while estimating this Cobb-bouglas production function taking output in terms of value added by manufacture,
They are, however, retained os intermediate inputs in this
production function, when as assumed, they enter the production
function in the fixed proper tions or they are perfect substiuj.'. ^
among themselves ao well wi th the piimary inputs K and L.

2 /

Walters A.A.: An Introduction to Econometrics, (MacMillan and


Co,Ltd., London, T 9 * 6 8 ) , p".275.

3 /

An additive error term log u, with mean of zsro and a constant


finite variance has been assumed here and other subsequent equa
tions.

A.513

This linear function is conveniently used in the inter-industry


group comparisons. cX and

are pure numbers, which can easily

be compared among different industry groups.

The sum of these parameters { o< and E> ) shows the dogres

1/

of "returns to scale" in production,

p !>
+ p

o(

f
such a s :

<

1 : decreasing returns to scale

>

1 s increasing resurns to scale

! constant returns to scale

The sum of these coefficients shows the degree of homogeneity


of this function.

Thus Cobb-Douglas production function is homoge-

+ p>

neous of the first degree when

is equal to one.

The maroina;

rate of substitution between factor inputs is unity.

A.5.1

Estimation of Marginal Productivity


Elasticity of the individual factor inputs is assumed to bo

less than unity; hence their respective marginal productivity falls


with corresponding increase in the output.

This means that the output,

grows at a decreasing rate with the increasing levels of factor Inputs .

Tho average and marginal products are proportional.


factor of proportionality is the associated exponent m

The

tho consiJo;cc

production relation,
for examples
(a) Marginal productivity
of capital (MP,,)
K

Average capital
productivity

Klein Lawrence, R.s An Introduction toJlcof^jijgtxics^, (PrenticeHall of India Pvt. Ltd., 1969), p.92.

(b ) M arginal p r o d u c t i v i t y
o f Labour (F'1P? )

Average Labour
productivity j

Tn& roo coin.-J r y f r of tvcr-rico . m o s c l cue m u c

-j'.. .u u

'-oi

labour and that of labour for capita.1


* can bs 8si>fn3tod using the
marginal productivity indices of capital and labour as under s

( c ) - a r a x n a l r a t e c:f 'c e c b rc cai


s u b s t i t u t i o n of c a p i t a l
f o r la b o u r (MfiTS^ )
B-Tld

Mr3,

K
TP

(d) Marginal rate of technical


suostiiufcion on iaocur for
capital (MRrSj^,)

* K
i
v,C
11> 1
L.

The re llative changes in tns use of factor Inputs provide

an inclo.n o f e l a s t i c i t y o f t o c h o i r s ! '* ubsriiufcj cm


LTS

A P</L) / (K/L?
A MRTSRL/ M RrSKL

(ETC-/ - > 'ht r s


(1)

nos important charset eristics of factor inputs m's hr,own on the


basis o f the coefficient of elasticity cf technical substitution.,.

Thus

When C7 ~
and

fsctcc input.!

&

"

.;>

r.sd mro.;,-v,i

when C7S s=cj- faccor .inputs a m oerraoc mtsf ituto;

o,~

each other
Higher value of ETS leads to the hignec degm-e of subatitnf, nbl.ity
between factor .'.npurs .

fi.5s5

ft.5.2

Elasticity of Substitution of Factor Inputs s


Cobb-Douglas Production Functions
The Cobb-Douglas production function dealing with two-

factor production situation

capital and labour defines the

elasticity of substitution as a measure of the relative responsive


ness of the capital-labour ratio to given percentage changes in
the marginal rate of technical substitution of capital for labour
1/

" RTV
b represents the coefficient of elasticity of substitution,.
where

b e.ETS

MRTS
Kl
. ^HsZkL. / A____

' (K/L)

FIRTS

(D

'KL

Alternatively this car. be written

b =

(2)
kl a

where?
k
k stands for the capital-labour ratio (*j~.)5 s stands
for the ratio of the marginal papduct of labour (PIP. ) over the
'L.

marginal product of capital (PIP ), dk and ds stand for the


2

variations in k and s respectively along a constant product curve,


b refers to a pure number that measures the rate at which substitution
takes place between factor-inputs.

I W S ^ is the slope of the

product isoquant.

JL/

Ferguson8 C.E.s Microeconomic Theory,, Revised Ed, (Homewood ,XII|

Richard D, Irwin/ Inc. 1969)f pps381-385.

2/

Allen,ft.G.04 Mathematical Analysis for Economist (London, fiecHillan and Co. 1930), p p 5340-344.

A5 ?6

ctk' t h r f's-rtyrirp!..-:.:' l a b o u r and c a p i t a l - f o r


a f f s e t i n g an o p t i m a l r e s o u r c s a l l o c a t i o n , a r e combined i r s u c h
a way t h a t t h s r a t i o o f t h e i r m a r g in a l p r o d u c t i v i t i e s i,:> aciuei t o
one r j t i o or' fsex o r - p r ..

m,t.

mrts

(3)

IS*

w here u = t h e p r i c ? a r : a o c u r , and
r the p ric e of c a p i t a l .
E q u a t i o n ( 1 ) can ba r e w r i t t e n a s ;

A (k./y / A(w/t
" ( k/D V T f c ) ~
(5)

or

f o r e x a m p le r fcbaxo i s s '|0 p e r c ^n t ir-cvao.sc ir- t h e o r i '


o f lab o u r r e l a t i v e t o th e a r ic e of c a p i t a l s t h a t I s

%A
or

(w/r)

~ 10

A.(w/y

r= oi

{w/r}*
t h e c a p i t a l ~ l a b o u r r a t i o i n c r e a s e s by 1G p e r cant,, t h a t i s s

%. A

(K/L)

k^ lT

= 20

T his i n d i c a t e s o b v i o u s l y t h a t b ( e l a s t i c i t y of s u b s t i t u t i o n
in c n ? 0
j/

Tn.ts rr.sans th.'-t

giv-rn

v;,-;.!';egc nb-intjO

. iv /;- ,

f l t e h e f c t , O a l b R r t , A.s " C a p i t a l - l a b o u r s u b s t i t u t i o n i n t h e
M a n u f a c tu r in g s e c t o r of Panama", i n Economic Development, and
C u l t u r a l Change, V ol.2A f A p r i l , 1976.

A* 5 ;7

In an equal percantage change in (K/L).

Ur> the oth er banc. i f A ( k / L ) i t 5 per c e n t , the"


b 0,5
and

If / A (K/L) I*- 2C psr cent, insr

Variations in the ratio of unit labour cost to capital


rental.i thus results in .either greater ih^n.

loss thar' or

-r...iXy

proportionate changes in capital per unit of labour employed


according as the elasticity of substitution (b) is greater then,
. /

j-^ii'Sc

than or squat co unrcy*

:*)r

vV

j.

u,,r

thus measures the changes in the factor combinations in response


to the relative price, changes.

It measures the ease with which

labour can bs substituted for capital (or vice-'/eras) with output,


remaining constant.

It determines also the relative factor shares

accruing to labour and capital.

For Instance, tho relative share- of ioccur (wLj nr t;;.-,


wage rata times ths quantity of labour, and share of capital (rK)
or the rate of return on capital times the quantity of rapei'e? in
the total output x is
wL
X
an:

f j

(6)

17)

Williams, Randolph L.s 'Capital-labour substitution in Jamaican


Manufacturing', The Developing Economies, Vol.12, No.2 . 1974,
p. 170,
'

A5 50

so that the ratio of relative shares is

ft

'

<>

W h e n b ~ 0 o S 5 an increase of w/r by 10 per cent causes


th s increase in K/L by 5 per cento
This means that
capitals

Thus wL/rK. increases also.

as labour becomes mor e expensive relative to

the entrepreneurs

substitute capital for labour,

ths extent production technology permits,,

to

8ut as the production

function is characterised by less than unitary elasticity


substitution of capital for labour cannot

be carried out in the

sam e proportion as the change in the relative factor pricss


This snakes the labour's share to increase

In the two factor-inputs case when ths return to one


factor increases relative to the return to the oth e r f a c t o r 5
the relative share of th e former increases

remains constant

and/or decreases according to whether the elasticity of substitution

1
/
(b) is lass then
in b always

equal to and/or greater than unity

An increase

raises the rate of increase of output and a decrease

y
of uhich reduces the output rate.

h S O p . c i t p.581

_1/

Fitchett Delbert

2/

Broun Murrays 5Technological Progress in the Theory of


Production' (Ch2) in On %he Theory And Measurement of
Technological C h a n g e (Cambridge at the University Press

1966).

A . 5 ;9

A -5 o2

CONSTANT ETLAS7 IC .7Y H- SUSS . 17U . i.1!

(ccs) FP.ooucnem

fu-mctigk cstip,att. qk-;

Constant-elasticity

of s u b s t i t u t i o n

production

funriior

J/
(popularly

known,

production

function.

function

cf

ss

unitary

production

handj

CSS

production

It

special

case,,

It

of

function,

line C E S

an

along

Cobh-Douglss

the

rsmavss

production

known

production

tbs

the

constant

ment

the

of

CES

elasticity

production

c
Y

is

bK

output

function

(net

ocher

However,

put

of

sub

forward

or

both

by

them

/
The

formal

state

i s

/r

(D

(l-b)l

value

the

v / j?

P \
-n

c r.

elasticity

substitution.

~p

Y ss
where

of

Limitation

{U O U 5 -.? !

characteristics

function.

of

production

function,

of

~.1sb~

r.sw

by

2
presume

serious

shown

measurement

other

in

Cobb-Douglas

substitution

explicit

with

function]

includes

elasticity

provides

stitution

the

as

added

by

manufacture),

and

are

3/
UDriabie

are

irsputs-CEpitai

parameters;

and

labour

represents

respectively,

the

degree

of

end

a,

homogeneity

and

of

the

function.

'}J

Arrow,
or

Cher.ery,

production

BeS . P i i n h a s .
and

2/

Sarthwal

end

R.fl.

H.fi,;

Solouj

"The

lasts

for

Indian

CES

function

its
of

is

limited

spsc.ificat.ion
production

K.3.,

of

this

HB,

"Capital-labour
Review

Economics

W o , 3,

production

popularised

Arrow

new

class

Chenery,

substitution

E c o n o m i cs

and

S t a t i s tics

1961.

R e v i e w a Uoi-4,

Function

Solow

See

L f f i c i e n c y *

N o , 3,

Empirical

3/

and

Economic

\Zol.43,

M n h a s

function.

is

1975,

to

of

Paper

Industry**,

p.174

unlike
two

Production

S o u t h e rn
"

the

CobbDouglas

factor-inputs.

and

estimation

with

very

difficult,

if

Function;

more

not

Some
Economic
~

product ion

This

is

than

two

impossible.

because
factors
CES
Contd.

4 . G 31 C

CcS production function bee three parameters - two


introduced es constants of integration and one elfcributaoie to
the assumption that elasticity of auSstitution ic eon? lent <.
2, b and f

are resosetivsiy called tns efficiency parameter,

1/
input intensity parameter .and substitution parameter,
also referred toss the Hicks ~ neutral parameter,

z is

The role cr

2 in CES function is identical to that of A in the Cobb-Dnuglu3


production function,

A change in z parameter changes the output

for any given set of inputs in the same proportion.


parameter 2 shows the efficiency of technology.

The scare

The efficiency oaracister (2) can be made eoual to one


by appropriate choice of output unite,

Equation (1) above is

a class of function known in the mathematical literature as


a mean value* of order

3/

5/

Contd..,
production functions, however, have been estimated taking
more than two factor-inputs. Sees Mukerji, V, >!"he CES
or SMAC Production Function with more tnen two Inputs;
A Generalization",
Indian Economic Journal, Vol.1?f No,3,

1964-65.

...

- -

j/

alternatively known as distribution parameter.

2/

Crown, Murrary s Cr> the Theory and Measurement of Technoloo.s.cai.


Change, (Cambridge at the University Press, 1966)',
p,"45

3/

Arrow K.3,, H.B, Cbenery, 8.S. Minhas, and R.tt. Solowt "CapitalReviaw of Economics

labour substitution and Economic Efficiency"


and Statistics; Vol.43, No.3, 1961, p,23G.

n5si *

The elasticity of substitution (

) measures the

relative chance in the facto"-input ratio In rasporr'j t:.

relat-iva

*i

change; ir; the rats of technical substitution.

Here.

fsr

equivalent to

-sbsfc.ttut.ion parenstev as referred to 3bt


a function of the constant elasticity of substitution asj
p

__ _ (1 - <?)

' }

The CES production function contains an unspecified


constant elasticity of aubstitufciou.
production function If

c'

production function when

It reriuesa to the Cobh Oouqac

becomes equal fcc 0-1


2/
P
approaches zero.

and to fchti LtnrtiSi'


The important

restrictions (.limiting cases) here are that


b
and

oo

<

>

The required non-negativity


upon

does noi; place a sigp restnetiur

t'-'ci.:gn

>a
JJ

3>

Kanthi, Mahendrs 5., and Pam Dhsiiwal* The Theories of


Production s A Survey" Arfcha-Uikas, Vcl.XI, No.l, 3ari.
1 9 7 5 , p . So

See aisoi Henderson, 3.M., and R.E, Quandt; Pllcrp-ecpnmnlc


Theory; A Mathematical Approach (McGraw-Hill Book Company,
New York, and Xogakusha Company Ltd., Tokyo, 1971) p.S'6
2/

When ^equals zero (input-output production function) chan-rc


In the ratio of unit labour cost to capital rsr.ts' (u/'j '
isavs the capital-labour (K/L) ratio unchanged.

_3/

the lowest admissible value for P is -1, which implies an


infinite elasticity of substitution.

A5 s12

f ~O s

When

<5%= 1? it shows the unit elasticity of substitution.

Anri this reduces equation (l) to the Cofab-Doualas production function.


It becomes

(*)

Y = ZKb L 1 b
further,, when

P>

-1, the isoquant showing relation between factor-

inputs K and L gets the right curvature.

^ __j. +

p= -1,

o o 3 the said isoquant bocomes a straight line isoquant.

the factor inputs are perfect substitutes.

P >/ 0
0,

And when

And when

P<

0 and

Here

no much significance is attached to the isoquant? for in

the case when

This is because whan

f <. 0,

the isoqusint intersects K and L axes, and when

0 < << 1. the isoquant is asyfntotic to both the axes.

ipO, <^>0, substitution is impossible and it reduces

the C5 production function to the Leontief production function.


1?
the curvature of the isoquants approaches a right angle.

Here

It is to be noted that the distribution parameter b always


lies in the interval (0,1).

It determines the functional distri

bution of income for any given value of <5" .

Further, any given

values of 6 and r'IRTS (marginal rate of technical substitution),


the nearer the value of b to one, the smaller the labour to capital
2/

input ratio.

This is in the sense that M R T S ^ ^ (marginal rate of

technical substitution of labour for capital) rises at a given


C3pital-output ratio.

3/
2/

The production process becomes more capiteil

Henderson 3.M., and R.E. Quandts

MRTS.a
LK

MP

PIP,

P8?.

A.5:13

intensive at any production point? wnsn b is r.oarsr erg,


refers to input intensity.,

Thur,. b

It indicates hers tna degree to -w'.ich

the technology is capital intensive.


{but not Identically thp name as)

It is closely related to
C

O' in the case of the Cctb-i

production function.

Uhon ^ y 1s -1 <" f* < 0 5 the factors of production resemble


each ether from technologies: 1 point of view,,
axes.

Isoquant cuts both '.ho

Here, if one factor-input increases indefinitely with the other

factor-Input. regaining constant, the existing technology oermtts the


increasing factor-input to be substituted relatively easily for the
constant factor-input.

For example, with the capital growing relative

to labour, capital becomes and/or treated as relatively cheap factorinput and is substituted for tha relatively expensive labour.

The

corresponding technological process becomes capital intensive. Alter


natively, it becomes labour intensive, if labour grows and is available
reletivrly cheaply and abundantly; wbjcn sases the substitution
process - substitucing labour for the relatively expensive capital.
Either of these two factor-inputs tends to bring in non-neutral
technological change in tha production process.

Both the factor-

inputs may increase indefinitely.

On toe other hand, technology considers the factor-inputs


so being relatively dipsimiiar If

if' < 1.

It is difficult, hers,

to substitute the increasing factor-input for the constant one (less


abunoant factor-input).

The output does not increase even if one

ASe14
factor-input increases indefinitely.

The technologically .less

abundant factor-inputs, therefore, restrains the growth of the output.

The non-neutral technological change, as defined above,


nc-wever, affects the output level-

This means that increasing

or decreasing capital intensity chancsa the output level; although


the same depends on whether capital grows far exceedingly than labour.
Ths increasing capital

intensify may raise the output level if '-.aocur

increases less rapidly than capital, and alternatively it may dsciease

the output level if it is relatively a slow growing fector-input.

shows the degree

o f

returns to seals; henco

when
^

constant returns to scale

if

>

increasing returns co scale

\r

<

*5

decreasing returns to scale

The C5, unlike the Cobb-Douglao and the Lsontief prediction


functions, allows the elasticity of substitution (
constant value.

<f

) to take any

Since it is not tied up with ths unit elasticity

(like the Cobb-Douglas production function), it shows the direction


of change in relative factor shares.
stitution (

(S '

Hero ths elasticity of sub

} is assumed to be invariant to changes in the

capital-labour ratio but free to take any positive value between


. . .

5./

zero and infinity.

ynG

assumption of chc constant elasticity of

j/

Brown Murrays O p . c i t p.50,

2/

Brown Murray; op.cit., pp.26-27.

3/

Williams Ranoolph L.: "Capital-Lacuur substitution in


3amaican Manufacturing", The Developing economies, Vo 1.12,

Wo,2, 1974, p.171.

A.5 s!5

substitution in this function;, though imposing restriction on the


form of production possibilities, helps to arrive at certain estimate,
when the general formula of the elasticity of substitution does not
allow fur its direct calculations.

The CS production function eliminates the difficulty


encountered with the Cobb-Douglas production function, which requires
estimations of both capital and labour inputs for estimating the
corresponding pararnoters*

Capital stock data (in fact the utiliza

tion rate of the services of the capital stock) are fairly difficult
to gat.

The following logarithmic form of the CES production

y is
function

used in the present exercises


y

Log ^

Log A + o{ Log y- + u

(5)

where s

2/ i,

-pis the labour productivity,

is the morssy wage

rate, Log A is the intercept, c( is tho coefficient of slasticity


of substitution and u is the error term .

1/

Arrow, Chenery, F.inhae and Solows Op.cit., p.228, and also


see Plukerji, V.A: "A Generalised SHAC function with constant
ratios of Elasticity of Substitution1*, Revi ew of Economic
Studies, October 1963, p #225.

2/

Labour productivity = Wet value coded by manufacture per Ictou. .

A 5 : 1 6

A lines: relationship between the logarithms of *~


and

generally givss a good fit by ordinary least squares methoc

The slanticily of labour productivity u.r.t. wogs rats is constant and


equal to

o<

. A

profit maximizing behaviour of firms in competitive

product and factor markets is assumed hers.

Arrow, et.al. showed

the coefficient of Log in equation 15) to bs the elasticity^ of


substitution cf a linear homogeneous CCS production function of tns
form as per equation (1 ) referred to above.

Tills means that a

fairly good seal of generalization of the Cobb-Oouglas production


function is made here,

Srhen

ot

in equation (5) becomes equal to

one, equation (5) refers to a special case of Cobb-Oouglas production


function.

A competitive equilibrium conditions arcs assumed ir the

given industry or industry groups while estimating tho CES production


function.

The empirical results, here, incicace, however, that


f

elasticities of suoititution ( d ' ) tend to be less than one.

And

here, the CES departs from the CobbDouglas production function,


lillian's has suggested :uo alternate method; of estimating elasticity

2/

For easy handling of this estimation, it has become the


popular method of estimating the elasticity parameter.
Set alsos Nerlove, Mj "Recent Empirical Studies of the CCS
and Related Functions" in Tha Theory end Empirical Analysis
of Production. National Bureau of Economic Research, Studies
in Income and Wealth, Vol.31, (New York s Columbia University
Press, 1967).

A5s1?

1/
of substitution between the factor inputs.

A.5.3 (1) Alternate Methods of Estimating Elasticity of


Substitution;

1st Method:
Log ~

log A

{ p Log V
I

Log A. is the intercept,

j$

(6)

x
=>
is the capital productivity,

where

+
9

is the coefficient of elasticity of substitution and V

is

the rental charge per unit capital employed.

Both equations (5) and {6) are the log-linear forms of


the marginal productivity conditions for capital and labour
respectively for'maximising a profit function subject to the
production function as per equation-(1) above.

The intercept

terms in equations (5) and (6) can be defined in terms of the


parameters of (1) as s

and

log S = (1- (S' )

Log Z - <s' log (1-b)

Log

Log Z ~ <s"log b

= (1-^)

2nd Method g
Log ~~
where wL
rf.

= Log fi2 + f 3 Lag k

+u

(?)

is the ratio of the relative factor shares, Log A-,


1

is the intercept, ~ is the capital-labour ratio, and

is tho

coefficient which helps to estimate the elasticity of substitution


( <Z )
\J

SSI

Williams Randolph Ls Capital-labour substitution in Jamaican


Manufacturing ,-The Developing Economies, Uol12, No,2, 1974,

P.171-1S2.
2/ Capital productivity = Net value added by manufacture par unit
capital employed.

A.5 s18

(i-

as referred to above in equation (3),


Here? the intercapt Log A2 can be defined in terms of equation {1}
13 8

'

Log A, Log (1~b)

-g ~

i/
The relative factor shares method has been used by Kravis,

and Bell

Solow,

to estimate the elasticity of substitution.

Solow, whils using this CES production function contends


that a regression of the labour productivity () on the wage rate
ly shows a highly significant correlation in most of the industries,
though having a considerable variation in the regression coefficients
( ot ) among them.^ Different degress of substitutability are found
in different types of production technology existing in different

1/

Kravis, I .8.: "Relative Income shares in Fact and Theory"!


American Economic Review, Uol,4S, Mo ,5, 1959.

2/

Solow,, RM.^"Capital labour and Income in Manufacturing"


in The Behaviour of Income Shares, National Bureau of Economic
Research, Studies in Income and Health, Vol.2? (Princeton, N.3.
Princeton University Press, T364).

3/

Bell, FW.s"A Note on tha Empirical Estimation of the CES


production function with the use of capital Data", Review of
Economics and Statistics, Vojl.47, No.3, 1965.

Solow, R
op.cit.

. M . sCapital,

Labour and Income in Manufacturing,"

A .5 j 1 9

0r o u p s .

Industry

same

industry

technological

marginal

i,n

the

the

Such

groups

among

set

differs

up

difference

csss

same

The

function

niven

they

are

further

from

noticed

of

on

the

croup

assumes

tnem

across

the

linear

to

be

even

the

in

fact

another.

factor

within

same

for

cauntryto

ir, t h e

firms

pronounced

countries,

one

i a d u s t .r-

mo: e

are

different

be

aggregation

that

and

nav

cne

country.

envisages

c;if f e r e n c e s

tics

chat

But

very

substitutability

the

suc-.egj.ons

same

industry

homogeneous

operating

of

groups

production

ir, p e r f e c t

2/
markets.,

But

belonging

well

to

this

the

defined

market

operating

under

t\

Arrow,
pp t

2 /

more

K j ;

but

the

rather

model

has

fh&asry;

In

spread

do

fact,

across

have

to

assumption

competition

general

and

on

seems

been

to

operate

and

RJ1.

t i u t n

undor

are

linear

theoretical

suggested

i'.inhas;

they

same

be

fi.-m.

space

that

the

the

by

i" o l d u t :

S c l o e : o p .clt .

226-227.

Ohrymes

has

provided

geneity

and

perfectly

functions",
1965;
of

broad.

region,

Thus

function

H.B.

very

group'

given

perfect"

'Sortie E x t e n s i o n s

and

substitution

1970.
data

and

3.8.

Kadsnes

partly

functions",

tost

ic s ! :

of

P.3.,

Two Digit
of

such

the

Uis

Economics

Ohrymes,
for

o;

ccmpt.itive

of

Review

However,

s r - :'

Review

also

Correction",

3/

of

condition?.,

the

is

incuctry

production

limitation.

^/

same

boundary

different

homogeneous

assuror ioc

is

and

least

spur res

Hates

on

the

Economics

feldstein,

M . S .{"Alternative

Production

function

for

o e s -

of

Zarembka,

and

bias.

Methods

Britain",

JLno.fr

cl

Homo
o

Just. ,.>i
No.-i,

P .{"Elasticities
Industries:

Statistics,
iuc>

Vol.52,

partly

cn

of

LtS

No.1,
'o f r:i s o t

oroc.uctj.vr

S tatistics, lol.AS,
of

S u e rMar'a 1: ,

Estimation
and

of

Ohry.no

5 t a b l e t leu,

inconclusive

to

of

rsr:

Manufacturing

S o m e
Review

Cf l
anc

Economics

test,

assumptions
markets

Estimating

E c o n arnica,.

Uol.34,

No.3,1966

CES
M o . 136.

't C 'l

A 5 s20
which incorporates the conditions of both perfect and imperfect
markets, while estimating the CS production functions for British
manufacturing industries.

Whether in fact, the firms belonging to

the same industry group(at the stats or the regional level) are
operating undar perfect or imperfect market conditions, the trua
values of elasticity of substitution (

) between the primary

factor inputs (K and L) may be different from what is estimated,.

The bias is upward if the true value of


unity5 whereas it is downward if the true value of

1/

than unity.

(S' is less than


df ie greater

At the same time, since the output-mix even within

the same industry g-roup across space, being slightly varying, a


similar bias may arise? hones the interpretation of the estimated
values of the elasticity of substitutions ( ) as given by the
coefficient cK in equation (5) above, needs s.irification on the basis
of other relevant information pertaining to the concerned industry
group in a regional context.

1/

Grilichss, Z.s "Production Functions in Manufacturings


Some Preliminary Results" in The Theory and Empirical
Analysis of Production, ed. ft. Brown, National Bureau
of Economic Research Studies in Income nr.a Wealth,
Vol.31 (New York, Columbia University Press, 1967), p.289.

A,5 s21

A.5.4

A CHOICE FOR THE PRODUCTION FUNCTION F OR THE


ESTIMATION OF THE ELASTICITY OF FACTOR
SUBSTITUTION!
The production function states the output levels through

utilizing alternative levels of a series of inputs.

The most

popular form of the two-factor case production function is the


Cobb-Oouglas

production function!

X = CXl.1-0<
where

X = output

'

(1)

(value added by manufacture),

K as capital and L = Labour.

A, and

a r c constants.

This form of production function,

however, is of

little use for it results into unitary elasticity of substitution.

A.5.4(1)

Derivation of the uni tary Elasticity of Subst i t u t i o n;


dX
nPL =

dL

Hp K

dX

,
,
o< o<
(l-cx) AK
L

= o< AK

0)

(2)

dK
Hence;
MRTS

-o<

( i~<)
C* AK

'!<L

AK

CK~1

HP,"

KL

MAT!

1/

wL

1/

_ ]
L

1- o(
L

P)

(4)

MRTS^^ = Marginal rate of technical substitution of capital


for labour.

A .5 s22

The elasticity of substitution can be transformed as follows*

"

A ik/Q
"v:./rv
(k / l )
b -

/ Am'V

m
qtc^ |
wa r s

A(K/t)

wrtskl

( k/

MRTSk i

(5)

l)

and deriving (4) with respect to (K/L),

d PIRTS..

dwrr

Thus,

(6)

1-o<

*N V

the elasticity of substitution is


Q\

1-o<

cK

Jii/kL

CK

PIRTS,,.

isL

PIRTS,
XL

(K/L)T

substituting (4) for PIRTS,

XL

(iW)ff ft

(?)

This means that b = 1 for all values of both the pasamsttru


and the independent variables .

And this makes Cobb-Oouglas production

function of practically no use to estimate empirically the elasticity


of factor substitution.

The CE5 production function permits the elasticity of


factor substitution to differ from unity,
constant.

The form of

tuhare X/L = val u e

though assumed to be

CES production function so used is:

added per unit of

labour (labour productivity),.