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3.1
Unit

Production Analysis

Short-run Analys is

Arjun Madan Ph D

Theory of Production

 Production theory forms the foundation for the theory of supply.

 Managerial decision making involves four types of production decisions:

 How much output to produce
 What input combination to use
 What type of technology to use
 Whether to produce or to shut down

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1. Production with one variable input

 In the short-run, a firm may not be able to adjust its use of many of its
inputs.
 The simplest case of short-run production is where the firm has a single
input whose use it can vary.
 The two key measures of a firm's short-run productivity are: average
product and marginal product.

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2. Production with two variable inputs

 In most cases, firms use many inputs to produce a product and, in the long-
run, have the ability to substitute the use of one input for another.
 It is the study of input substitution in which the firm can choose how much
to use of two inputs.

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3. Returns to scale

 As a firm produces more output, it may become more or less effective

at transforming inputs into outputs. This concept is known as returns
to scale.

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Production Function

 An empirical production function generally includes a wide range of inputs:

land, labour, capital, raw materials, time, and technology.
 These variables form the independent variables in a firm's actual production
function.
 A firm's production function is of the form :
Q = f (Ld, L, K, M, T, t)
 Where,
 Ld = Land & building
 L = Labour
 K = capital
 M = Materials
 T = Technology, and
 t = Time

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Production Function
 For the sake of convenience, economists have reduced the number of
variables used in a production function to only two: capital (K) and labour
(L).
 Therefore, in the analysis of input-output relations, the production function
is expressed as:
Q = f (K, L)

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Production Function

 Suppose that a coal-mining firm employs only two inputs, capital (K) and
labour (L) in its coal production activity.
 Whether the firm can increase both K and L, or only L will depend on the
time period. Accordingly, there are two production functions:
 Short-run production function (single variable production function)
Q = f(L)
 Long-run production function
Q = f(K, L)

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Production Function with One Variable Input

 Also called the short-run production function
 Help understand how output behaves with one variable input when all other
inputs are fixed
 For example - agriculture land being a fixed input the farmer can use increased
labour to increase the harvestable output.

 But this can not go on endlessly and eventually the output will decline!
 This is conceptualized as the law of diminishing returns or the Law of
Returns to a Variable Input.

 The short-run production function is explained using total, average and

marginal magnitudes

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Average & Marginal Products

 The average product of labor, denoted APL, is the amount of output that
is produced per worker.
 It is calculated by dividing total product by number of labour
TPL
APL =
L
 The marginal units of labor are the last units hired, where DL is the smallest
amount of labor an employer can add or subtract.
 The marginal product of labor MPL measures how much extra output we
get by hiring these marginal units of labor DL , per unit of labor added.
DTPL
MPL =
DL
MPL = TPL – TPL – 1

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Production in Short Run – An Example

No. of Amount of Garage Space (sq. ft.)

Assembly
workers 500 1000 1500 2000 2500

1 20 33 45 55 60

2 42 74 105 130 140

3 70 111 140 167 189

4 88 132 170 205 220

Q  F L   2 L3  10 L2  25 L

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Law of Diminishing Marginal Returns

 “An increase in some inputs relative to other fixed inputs will, in a given state
of technology cause output to increase; but after a point the extra output
resulting from the same addition of extra inputs will become less”. - P. A.
Samuelson

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Law of Diminishing Marginal Returns

 Assumptions
 (i) perfect divisibility of both inputs and output
 (ii) there are only two factors of production-labour (L) and capital (K)
 (iii) limited substitution of one factor for the other
 (iv) inelastic supply of fixed factors in the short-run
 (v) the state of technology is given
 (vi) labour is homogeneous, and
 (vii) input prices are given

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Production Function with One Variable Input

 To illustrate the law of diminishing returns, let us assume

 (i) that the coal-mining firm has a set of mining machinery as its capital (K), fixed in
the short run, and
 (ii) that it can employ more of mine-workers to increase its coal production.
 If there is no cost associated with the labour (labour is free) how many labour will
be employed by the mine-owner?

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No. of Workers Total Product Marginal Average Product Stages of

(N) (TP) (tons) Product* (APL) Production
(MPL)
(1) (2) (3) (4) (5)
1 24 24 24 I
2 72 48 36 Increasing Returns

3 138 66 46
4 216 78 54
5 300 84 60
6 384 84 64
7 462 78 66 II
8 528 66 66 Decreasing Returns

9 576 48 64
10 600 24 60
11 594 -6 54 III
12 552 -42 46 Negative Returns

Business Economics (Micro) – Production Function Arjun Madan Ph D Qc = -L3 + 15L2 + 10L 14

An Illustration

 Let us assume that the labour-output relationship in coal production is

given by a hypothetical production function of the following form.
Qc = -L3 + 15L2 + 10L
 we may substitute different numerical values for L in the function and work
out a series of Qc.
 For example, if L = 5, then by substitution,
 Qc = -53 + 15 x 52 + 10 x 5 = - 125 + 375 + 50 = 300

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Graphing the TP, AP & MP Curves

Consider a production process where Capital and Technology are
fixed: As L is changed, the output
Production of Good X
changes, QX = f(L)
L TPL APL MPL
L = labour input 0 0 0 --
TPL = QX = output of good X DL = 1 DTPL=4
APL = average product [TP/L] 1 4 4 4
MPL = Marginal product [DTP/DL] 2 10 5 6
TPL 3 20 6.67 10
APLL ==
L 4 25 6.25 5
DTPL 5 29 5.8 4
MPL =
DL 32 5.3
6 3
Maximum of APL is at the 3 input of 7 34 4.87 2
labour. 8 35 4.37 1
9 35 3.89 0
16
Business Economics (Micro) – Production Function Arjun Madan Ph D

Graphing the TP, AP & MP Curves

Production of Good X
L TPL APL MPL
Notice that the APL increases as the first three 0 0 0 --
units of labour are added to the fixed inputs of 1 4 4 4
K. The maximum efficiency of Labour or 2 10 5 6
maximum APL , given our technology, plant 3 20 6.67 10
and natural resources is with the third worker. 4 25 5
6.25
5 29 5.8 4
As additional units of labour are added
beyond the third worker the 6 32 5.3 3

output per worker [APL ] declines. 7 34 4.87 2

8 35 4.37 1
9 35 3.89 0

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Graphing the TP, AP & MP Curves

Graphically TPL can be shown:
TPL initially increases at an increasing L TPL

..
rate; it is convex from below. .
Output, QX
35 Maximum
. . . TPL
0
1
0
4
30 output
25
20 . . After some point it
2
3
4
10
20
25
then increases at a

.
5 29
15 decreasing rate and
6 32
10

.
5 . 1 2 3
reaches a maximum
level of output,
and declines
4 5 6 7 8 9
7
8
9
34
35
35
Labour
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Graphing the TP, AP & MP Curves

Given the TP , the APL can calculated: TPL L APL
TPL output 0 0 0
APL = = = Efficiency of
L input labour 4 1 4
10 2 5
20 3 6.67
APL
25 4 6.25
10
5 5.8
.....
29
8
6
4 . . ..
32
34
6 5.3
7 4.87
35 8 4.37
2
. 1 2 3 4 5 6 7 8
APL

9
35 9 3.89

Labour

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Output, QX
TPL

.
.
35 Z

.
..
The APL is the Graphically the relationship

.
30
slope of a between APL and TPL can be shown:
ray from
.
25 M APL is 4/1 = 4 or the
20
the origin 1 unit of L produces 4Q, slope of line 0H.
to the H
2 units of L produces 10Q,
15 TP .

10
L
. APL is 10/2 = 5 or the slope of line 0M.

..
3 units of L produces 20Q,
5
4 APL is 20/3 = 6.67 or the slope of line 0Z.
0
AP10 1 2 3 4 5 6 7 8 9 4 units of L produces 25Q,
L

.
Labour

. ....
APL is 25/4 = 6.25 or the
8
slope of line 0W.
6

4 . .. As additional units of L are added,

the AP falls.
The maximum AP is where the
2
. 1 2 3 4 5 6 7 8 9
APL ray with the greatest slope is
tangent to the TP.
20
Business Economics (Micro) – Production Function Arjun Madan Ph D

Output, QX
.
.

35 TPL

..
.

30 Given TPL , the APL was

calculated and graphed.
25
20 . MPL is calculated as
the change in TPL given a
change in L.
L
0
APL
MP
--0
L TPL
0
4-0
15
10 . The first unit of labour added
4 units of output.
1
2
44
65
4
10

.. .
“Between” the 1st and 2nd units
5 4 of labour, Q increases by 6. 3 10
6.67 20
0 4 6.25
5 25
AP10
L 1 2 3 4 5 6 7 8 9
5 5.8
4 29

.
Labour
8
MPL = APL
6 .
. .
. . .. .. . . .
Note: Where MPL = APL,
APL is a maximum.
6
7
5.3
4.87
2
3 32
34

.
4 8 4.37
1 35
2
. .. MPL
APL 9 0
3.89
Remember: MP is graphed
35

1 2 3 4 5 6 7 8 9 at “between” units of L.
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No. of Workers Total Product Marginal Average Product Stages of

(N) (TP) (tons) Product* (APL) Production
(MPL)
(1) (2) (3) (4) (5)
1 24 24 24 I
2 72 48 36 Increasing Returns

3 138 66 46
4 216 78 54
5 300 84 60
6 384 84 64
7 462 78 66 II
8 528 66 66 Decreasing Returns

9 576 48 64
10 600 24 60
11 594 -6 54 III
12 552 -42 46 Negative Returns

Business Economics (Micro) – Production Function Arjun Madan Ph D Qc = -L3 + 15L2 + 10L 22

Total Product Relationship between TP. AP & MP

700
The marginal product initially increases with
600
the quantity of the variable input used.
500
TP For example, the second unit of labour will
Output

400
contribute more to the total product than the
300 first unit of labour.
200
This phase is called increasing returns – this
100
corresponds to the range 0 – 5. MP > AP
0
1 2 3 4 5 6 7 8 9 10 11 12 Eventually MP begins to fall, leading to the TP
AP &Labour
MP increasing at a decreasing rate, and is called
100 Diminishing
80
Increasing
return Negative diminishing return - this corresponds to the
returns return range 5 – 10. MP < AP
60
AR / MR

40
AP The point where MP intersect AP, MP = AP
20

0 If we continue to employ more of the variable

1 2 3 4 5 6 7 8 9 10 11 12
-20 factor, the decreasing marginal product
-40 becomes negative.
-60 MP
Labour
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Three Stages of Production in Short Run

AP,MP
Stage I Stage II Stage III

APX

X
MP & AP both rise, Both fall, MP falls faster MPX
MP reaches max and than AP, AP falls and MP falls below x-axis
starts falling, when gradually gets parallel to and becomes
AP reaches max, MP X-axis. MP touches X- negative,
cuts AP at max point axis, End of Stage II. Stage of Negative
of AP. End of Stage I. Stage of Diminishing Returns
Stage of Increasing Returns
Returns

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Reasons for Three Stages of Production

AP,MP
Stage I Stage II Stage III

APX

X
MPX
Fixed input grossly Specialization and
underutilized; teamwork continue to Fixed input capacity
specialization and result in greater output is reached; additional
teamwork cause AP when additional X is X causes output to
to increase when used; fixed input being fall
additional X is used properly utilized

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Optimal Input Levels with One Variable Input

 The decision to employ an additional unit of input is based on the
contribution of that input to cost and revenue.
 So long as the contribution to revenue exceeds the contribution to cost, it
is contributing to the reduction in losses or to the increase in profits.
 How do we measure the contribution to revenue and cost of each
additional unit of the variable input?
 Recall the total, average and marginal magnitudes !
 The marginal product measures the contribution of the additional unit to
total product.
 By converting the physical product into value terms we can arrive at the
contribution to the revenue by the additional input.

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Profit Maximization with One Variable Input

This point can be proved as follows:

Profit is maximum where MC = MR
Since labour is the only variable input, marginal cost (MC) equals marginal
wages (MW), i.e., MC = MW.
As regards MR, in case of factor employment, the concept of Marginal
Revenue Productivity is used.
The marginal revenue productivity is the value of product resulting from
the marginal unit of variable input.
In specific terms, marginal revenue productivity (MRP) equals marginal
physical product (MPPL) of labour multiplied by the price (P) of the
product, i.e.
MRP = MPL x P

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Optimal Input Levels with One Variable Input

 Profit Maximization with One Variable Input
 In our previous example an output maximizing coal-mining firm would like
to employ 10 workers (if there is no cost associated)- since at this level of
employment, the output is maximum. (Output is 600)
 However, if there is cost associated, the question arises 'how many workers
will the firm employ - 10 or less or more than 10 - to maximise its profit.
 The number of workers to be employed depends on the output that
maximizes firm's profit, given the product price and the wage rate.

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No. of Workers Total Product (TP) Marginal MRPL Wage Rate

(N) Product* (MPL * P) $ 660
(MPL) $10 per Ton
1 24 24 24,000
240 6,60
2 72 48 480
48,000 1,320

3 138 66 660
66,000 1,980
4 216 78 780
78,000 4,640
5 300 84 84,000
840 3,300
6 384 84 84,000
840 3,960
7 462 78 78,000
780 4,620
8 528 66 66,000
660 5,280
8 66
9 576 48 48,000
480 5,940
10 600 24 24,000 6,600
240
11 594 -6 -6,000 7,260
-60
12 552 -42 -42,000 7,920
-420
Qc = -L3 + 15L2 + 10L

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