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4,

COST-OUTPUT

RELATIONS

A.4.1

COST AND OUTPUT LEVELS:

production and the output levels,

Cost * f (output)

used:

Output f (inputs)

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.

the second ono determines the level'of cost.

cannot influence the prices of the concerned factors.

Instead

to pay to the factor-inputs.

Thus cost is directly related with the output lavel.

Cost function expresses the relation between the output

and the corresponding cost.

A.452

function op output.

form ass

TC = a * &Q

(l)

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.

of output.

is a linear function

They

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

*?

*7

TC

sa a + btj +

cQ~

+ dQ

(s)

A 4 *3

When Q

0,

TC

a s and a

0.

/d o

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

d(WC)

- o

dO

i

0. 2c '5* SdU

'

~

fid >

d ir

minimum when

OR

6dQ

2c

is 2c

6d

~c

3d

iS~'3)

b < C

{'o*

d > 0

a h

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

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

**

o)

'/

of the relationshipc

1/

Dohncton D,

ft. 455

written S3 *

* b1 Xit + b2 X2t +

+ bR XKt * ut

(1 .2 )

(t 1,2, . . . n)

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.

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

A . 6 s6

I f ?.

' t-1

' j h a f O

t~1

t

FiC =

2bXt

(2.4;

2b2

2b_

intra-firm rgjationahio between costs and output.

1/

findings

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

1/

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

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

2/

Regression", American Economic Review. Vol.31, No.

1941, ppS332-335.

A.4S7

hypothesis.

Besides,

hypothesis is mads by' the inclusion of second or higher degree

terms in output.

These variations are characterised by the reference period.

Hsnce, it is useful to differentiate bstwsen tho short run and

the long run cost behaviours.

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.

(at the state level) industry groups teking a firm level cost

and output details.

A,4i8

A42

differsnt to that in the long run.

fixed cost, total variable cost end total cost concepts ara

worth examining. Total fixed cost is

n

TFC

P,X,

(1

'

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

output level.

output level.

the increase in the output level.

Thus, total variable coat is

m

ivc * ^

y:,

(2)

various kinds of variable inputs.

Tha total cost la ths sum of the total fixed cost and

total variable cost.

TC x TFC + TUC

CO

A4f9

total cost concept.

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

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

returns to variable inputa

whera8

Q is the output level0 x is the variable input and a is

ths constant

A.4*10

returns to variable Inputs?

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*

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.

TVC is continuously increasing with the increasing

output levels.

inputs, the output doss increase, as pointed out above, but

with tha increasing TVC.

and greater increments when ths variable inputs arc added or,

gradually and so is the resulting TVC.

But there is

A.4S11

and

that of TVC.

ing TVC increases at a decreasing rate.

Thus?

TVC bQ - cQ2

(1.4)

1/

from the origin.

Given TC = TFC + TVC

the total cost function can be written a s 5

TC - a + bQ - cQ2

<1.2)

(bQ - cQ2 ) represents TVC

TVC function ass

AVC - ~ ~ = ~ r - ~

a(b - cQ) b - cQ

(1.5)

variable cost falls with the increase in the output

(q ) under

1/

TVC = bQ - cG is the TVC function

<1}

(2)

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 *

Vi

VI

Under the

VI

rises with every increase of variable input.

function by Q as *

ATC ! a - t J & c s !

| + b - cQ

(1,6)

*

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.

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.

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

successive units of variable input. With the increasing MP

and Pyj remaining constant, MC must necessarily Fall.

returns to variable incuts

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/

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

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.

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

And

And, ATC under the condition of constant returns

to variable inputs is

ATC = T C = a + bQ

Q

Here, ~

&

+ b

(2.?)

equation ofs

ATC = AFC + AVC.

ATC curve is asymptotic to the horizontal AVC curve and

decreases throughout.

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

returns to variable inputs^

With the decreasing returns to variable input, MP of

variable input declines throughout the output (Q) range.

Each

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

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

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

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

Sine .

AFC

Q the

AVC

Cr-> b

4A,

Thus increasing

thg increase of AVC when Q Increases.

increase in AVC.

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

range for many production processes, although thoy are typical

of production and cost behaviour at near capacity levels of

output.

no

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

ssfc in*

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

1f

T!

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 .

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

7ha equation uf

TVC i

TVC bQ - acT -> dST

;?i,3;

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

Khar a

a t each v e lu a o f Cl

\<o4;

oO

. ciQ""1} rcpvoPHV. r- VC

JC

AVC

lQ - sq2 * dCT

b cQ + dQ

(4S)

increases.

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)

Howevero the minimum point of fchs ATC curve io at n larger

volume of output than ie the minimum point of the AVC curve.

AVC is minimum.

this makes ATC to turn upward.

And

irs

tha short-run.

nc s

dTC

dQ

dTVC

dQ

* b - 2cQ t 3dq2

(4.8'.'

A, ^20

raust ba decliningo

constant

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)

of different shapes of othar cost curves0

It

(2)

points of AUC

(3)

FiC reaches its nininura before fi'JC and ATS and At/C

reaches Its minimum before ATC,

A.4.3

function of output level ond plant sirs t

C-

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

(l)

the greater the value

In short-run5'ths

size.

1/

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

cost

c u rv e s .

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*

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

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

3/

2/

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

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

tested on a widB scale.

3/

functions

(a)

net U-nhapod.

(b)

of technological consideration.

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

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

i c m produce more output kith;

,

tnaraorlssSj, ths same minimum cost as before.

Ths rising part

manageable bounds.

3/

(Cambridge, 193S).

2/

Industry, (tendon, 1953)

3/

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

4/

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

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 .

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.

2/

study of business enterprisan0

siatsnt

11/

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

T?.o

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 "

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.

by

Ezakiol

sit her declining or ircrsasinc 0

bs interpreted as a deviation from the established theoritiecl

concept of declining MC in tho beginning sr.d rising

on

analysis of Indian industries could be cited,

However c mention

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}.

% [

to entry in Twenty-Nine Manufacturing Industries of India0 ,

The Journal of Industrial Economics, Vol.17, N o .1, 1958.

3/

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

4/

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

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

functions,,

industry as 3

Davis has used this rvps of aquation while testing the

2/

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

1/

among as many as eighteen cf :nssa industries

revealed a slightly rising leg of the L,

2/

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

2/

and breweries, and rice rr.j 13 ioo

3/

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

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

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;

if

industry groups, and does not embody any technological progress.

It is homogeneous of degree

oi + jb , where Ot and j$

measure

1/

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/

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

to K and L respectively.

relationship is loo-linear,

This

rero; in the absence of which the corresponding output levels cannot

bs defined mathematically.

production process.

case for capital.

2/

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

function by using the logarithmic transformation as:

(2)

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 /

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

3 /

finite variance has been assumed here and other subsequent equa

tions.

A.513

group comparisons. cX and

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

1/

p !>

+ p

o(

f

such a s :

<

>

of this function.

+ p>

is equal to one.

The maroina;

A.5.1

Elasticity of the individual factor inputs is assumed to bo

with corresponding increase in the output.

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

-j'.. .u u

'-oi

* can bs 8si>fn3tod using the

marginal productivity indices of capital and labour as under s

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

suostiiufcion on iaocur for

capital (MRrSj^,)

* K

i

v,C

11> 1

L.

LTS

A P</L) / (K/L?

A MRTSRL/ M RrSKL

(1)

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

Thus

When C7 ~

and

fsctcc input.!

&

"

.;>

r.sd mro.;,-v,i

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

Cobb-Douglas Production Functions

The Cobb-Douglas production function dealing with two-

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

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.

2

b refers to a pure number that measures the rate at which substitution

takes place between factor-inputs.

product isoquant.

JL/

2/

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

A5 ?6

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

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/

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

b 0,5

and

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

loss thar' or

-r...iXy

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

. /

j-^ii'Sc

:*)r

vV

j.

u,,r

to the relative price, changes.

remaining constant.

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)

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

p. 170,

'

A5 50

ft

'

<>

th s increase in K/L by 5 per cento

This means that

capitals

the entrepreneurs

to

substitution of capital for labour cannot

This snakes the labour's share to increase

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

1

/

(b) is lass then

in b always

An increase

y

of uhich reduces the output rate.

h S O p . c i t p.581

_1/

Fitchett Delbert

2/

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

(ccs) FP.ooucnem

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

introduced es constants of integration and one elfcributaoie to

the assumption that elasticity of auSstitution ic eon? lent <.

2, b and f

1/

input intensity parameter .and substitution parameter,

also referred toss the Hicks ~ neutral parameter,

z is

The role cr

production function,

parameter 2 shows the efficiency of technology.

The scare

by appropriate choice of output unite,

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/

2/

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

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

n5si *

) measures the

relat-iva

*i

Here.

fsr

equivalent to

a function of the constant elasticity of substitution asj

p

__ _ (1 - <?)

' }

constant elasticity of aubstitufciou.

production function If

c'

2/

P

approaches zero.

The important

b

and

oo

<

>

upon

t'-'ci.:gn

>a

JJ

3>

Production s A Survey" Arfcha-Uikas, Vcl.XI, No.l, 3ari.

1 9 7 5 , p . So

Theory; A Mathematical Approach (McGraw-Hill Book Company,

New York, and Xogakusha Company Ltd., Tokyo, 1971) p.S'6

2/

In the ratio of unit labour cost to capital rsr.ts' (u/'j '

isavs the capital-labour (K/L) ratio unchanged.

_3/

infinite elasticity of substitution.

A5 s12

f ~O s

When

It becomes

(*)

Y = ZKb L 1 b

further,, when

P>

^ __j. +

p= -1,

P >/ 0

0,

And when

And when

P<

0 and

Here

f <. 0,

1?

the curvature of the isoquants approaches a right angle.

Here

lies in the interval (0,1).

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

2/

input ratio.

C3pital-output ratio.

3/

2/

MRTS.a

LK

MP

PIP,

P8?.

A.5:13

refers to input intensity.,

Thur,. b

{but not Identically thp name as)

It is closely related to

C

production function.

each ether from technologies: 1 point of view,,

axes.

increasing factor-input to be substituted relatively easily for the

constant factor-input.

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

The

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.

so being relatively dipsimiiar If

if' < 1.

It is difficult, hers,

abunoant factor-input).

ASe14

factor-input increases indefinitely.

nc-wever, affects the output level-

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

Ths increasing capital

o f

when

^

if

>

\r

<

*5

functions, allows the elasticity of substitution (

constant value.

<f

) to take any

of change in relative factor shares.

stitution (

(S '

. . .

5./

ynG

j/

2/

3/

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

A.5 s!5

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.

encountered with the Cobb-Douglas production function, which requires

estimations of both capital and labour inputs for estimating the

corresponding pararnoters*

tion rate of the services of the capital stock) are fairly difficult

to gat.

y is

function

y

Log ^

Log A + o{ Log y- + u

(5)

where s

2/ i,

of substitution and u is the error term .

1/

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/

A 5 : 1 6

and

equal to

o<

. A

substitution cf a linear homogeneous CCS production function of tns

form as per equation (1 ) referred to above.

function is made here,

Srhen

ot

function.

function.

f

And

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

2/

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.

Substitution;

1st Method:

Log ~

log A

{ p Log V

I

j$

(6)

x

=>

is the capital productivity,

where

+

9

is

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

parameters of (1) as s

and

Log

Log Z ~ <s"log b

= (1-^)

2nd Method g

Log ~~

where wL

rf.

+u

(?)

1

is tho

( <Z )

\J

SSI

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-

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

13 8

'

-g ~

i/

The relative factor shares method has been used by Kravis,

and Bell

Solow,

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/

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

2/

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/

production function with the use of capital Data", Review of

Economics and Statistics, Vojl.47, No.3, 1965.

Solow, R

op.cit.

. M . sCapital,

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.

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 (

unity5 whereas it is downward if the true value of

1/

than unity.

df ie greater

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/

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

ESTIMATION OF THE ELASTICITY OF FACTOR

SUBSTITUTION!

The production function states the output levels through

The most

Cobb-Oouglas

production function!

X = CXl.1-0<

where

X = output

'

(1)

A, and

a r c constants.

however, is of

A.5.4(1)

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)

for labour.

A .5 s22

"

A ik/Q

"v:./rv

(k / l )

b -

/ Am'V

m

qtc^ |

wa r s

A(K/t)

wrtskl

( k/

MRTSk i

(5)

l)

d PIRTS..

dwrr

Thus,

(6)

1-o<

*N V

Q\

1-o<

cK

Jii/kL

CK

PIRTS,,.

isL

PIRTS,

XL

(K/L)T

XL

(iW)ff ft

(?)

and the independent variables .

of factor substitution.

factor substitution to differ from unity,

constant.

The form of

though assumed to be

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