PRODUCTION ANALYSIS Production is transformation activity that connects factor inputs and outputs. For example, a farmer uses land, labor and seeds as inputs to transform them into corn. An input refers to any good or service that assists in producing an output. A good or service may be input for one firm, but may be output for another. For example, steel is an input for an automobile manufacturer, but output for a steel producer. The process of transformation of inputs to outputs can be transformed in any of following three ways: 1} Change in form: E.g. transformation of raw materials into finished goods. 2} Change in place: .g. transportation 3} Change in Time: E.g. storagePRODUCTION FUNCTION Production function deals with the ma: a limited and given quantity of inputs. For example, the production function of a steel firm takes into consideration, various inputs like labor, raw material, power consumption, cost of land, etc. It also takes into account the quantity of output that is being produced, using all the above fixed and variable inputs. Thus, production function deals with input as well as output. A production function can be expressed as an equation, table, or a graph. Ifa firm uses inputs like labor (L) and capital (K), then the production function can be formed as Q=F(K,U Production function has no focus towards the least cost combination or the profit maximization. If the firm fails to utilize the available resources effectively, it may not be able to survive in the long run. Firms using the efficient production processes enjoy minimum cost but earn maximum profits. Example: ‘The production function of a steel company can have inputs like cost of procuring the ore, power charges, labor charges, etc. Whereas the production function of a tour operator can be cost of fuel, vehicle maintenance charges, wages and salaries of employees um output that can be produced withFACTORS Factors that are used for production are called factors of production. There are four important factors of production. They are — land Labor Capital Entrepreneurship The prices of these factors are rent, wage, interest and profit respectively. Factor of Production Price Land Rent Labor Wage Capital Interest Entrepreneurship ProfitsConcepts of Product There are three types of product concepts that are crucial to the production function. Total product Marginal product and Average product.Total Product, Average Product and Marginal Product Total product ‘The amount of output produced using a given quantity of inputs is known as total output. As the input increases, the total output also increases. For example, for a firm producing leather shoes, as the number of labor and the raw material is increased, output also increases. When the firm is using just a single labor the firm produces 2,000 units of shoes. On increasing the labor to three, the total output rises to 3,000. It can be observed that total product increases with the increase in the output, and rate of increase starts decreasing after reaching a point, which it can be observed in the TP graph as well. It can be seen in the graph that the total product rises by smaller and smaller increments as additional units of labor are added. TP curve rises initially and starts declining after reaching a point.Average product ‘Average product can be defined as the total product per unit of factor ‘employed in the production process. In the given example, average product is 2000 with one labor, every additional labor has resulted in the fall in the average product. Marginal product Marginal product can be defined as the extra product or output added by one extra Unit of that input while other inputs are held constant. In the given example, it can be seen that the first labor can produce 2000 units of shoes alone, i.e. the marginal product of the first labor is 2000. On adding one more unit of labor, total product increases to 3,000, resulting in decline in the marginal product. With addition of each labor unit, marginal product keeps declining. When the 6" labor unit is added, marginal product becomes negative. Marginal product helps in determining the wages of the labor. Based on the ‘marginal product, the firm can arrive at the cost and output relationship of each additional labor. The concept of marginal product also helps a firm to allocate the scarce resources of the firm. For example, in the given case a firm could have avoided adding the 6" labor, as it is resulting in the fall of total product itself.The Three Stages of Production Based on the law of diminishing returns, Prof. Cassels proposed three stages in the production process. Stage |: Stage | offers increasing average returns to the factor of production, i.e. (Q/L)/BL > 0 or MP, > AP. Thus, in stage |, average product increases and the marginal product is greater than the average product. Stage II: In stage Il, the average product decreases and so does the marginal product. But marginal product remains positive. This stage may be called the stage of decreasing returns. Stage Il: In stage Ill, total product decreases and the marginal product becomes negative.AP, The Three Stages of ProductionPoints to Remember When MP = AP, AP will be maximum When MP = 0, TP will be maximum Stages of Marginal Returns Increasing marginal returns: From the starting point of MP until MP reaches its maximum point. Diminishing marginal returns: From the maximum point of MP until MP = 0. Negative marginal returns: From the point where MP = 0SHORT RUN AND LONG RUN Time period can be classified into short run and long run based on the nature of factors of production. Short run refers to a period of production where all factors of production are not variable. The period defers from industry to industry, country-to-country, and firm-to-firm, etc. Example: Matchbox industry day Soap industry one year Shipbuilding industry 10 years Long run refers to a period of production where all factors of production are variable.Products Costs in the Short Run Law of Diminishing Returns) Inthe short run, the shape of the total product (TP) curve is determined by the law of diminishing returns. Law of Diminishing Returns (also known as Law of Variable Proportions) states that given the state of technology, if, we go on employing more of one factor of production, other things remaining the same, its marginal productivity will diminish after some point. Assumption Law of diminishing returns is based on the following assumptions. State of technology is constant. One factor of production must always be fixed. Thus, this law is not applicable when all the factor inputs are variable. This law is not applicable when the two inputs are used in a fixed proportion. This amounts to say that the law is applicable only to varying ratios between the two inputs.Product Costs in Long Run Law of diminishing returns is operational only in short run because of its assumption of one fixed factor input. But in the long run all the factor inputs are variable. Law of Returns to Scale: It refers to the long run analysis of production. According to the law, the long run output can be increased by changing all the factors in the same proportion, or by different proportions. ‘As all factor inputs are variable in the long run, the production function is. given by Q=f(k,y The returns to scale may be of three types - Constant returns to scale Decreasing returns to scale Increasing returns to scaleTypes of Returns to Scale a.Constant Returns to Scale: If the proportionate change in output is same as the proportionate change in input, then we say that there are constant returns to scale (CRS). Symbolically, CRS: % AQ = %AI b.Decreasing Returns to Scale: If the proportionate change in output is less than the proportionate change in input, then we say that there are decreasing returns to scale (DRS). DRS: %AQ < %AI Increasing Returns to Scale: If the proportionate change in output is more than the proportionate change in input, then we say that there are increasing returns to scale (IRS) IRS: %AQ > %ATReturns to Scale Returns to scale show the responsiveness of total product when all the inputs are increased proportionately. Returns to scale is a factor that is studied in the long run. Returns to scale can be constant, increasing or decreasing. Constant returns to scale In this case, the change in inputs results in propor nal change in output. For example, if a firm is using three factors of production, land, labor and capital, and if it doubles all these inputs, output should also be doubled.Increasing returns to scale: When rise in inputs result in more than proportional increase in the output, it is known as increasing returns to scale. For example, if a plant is producing 100 units of the product using 10 units of labor and 100 units of capital. If the labor is doubled to 20 units and capital is also doubled to 200 units, and the output generated is 250 units, then the firm is operating at increasing returns to scale level. Decreasing returns to scal When increase in all the inputs result in less than proportional output, then it is known as decreasing returns to scale. For example, if a firm increases all its inputs by 20 percent and the resulting increase in the output is just 15 percent, then it is the case of decreasing returns to scale.THE PRODUCTION ISOQUANT If a firm is having two variable inputs, the approach to determine the optimal input rates is completely different. In this scenario, the problem of efficient resource allocation can be solved in two ways Maximize the production, utilizing the available resources. These two problems are known as constrained optimization problems. The problem of resource allocation can also be solved by producing the profit maximizing output. Isoquants also known as production-indifference curves, represent the ‘combinations of inputs that produce same quantity of output. This can be explained with the help of an example, Factor Combinations bor Capital A 2 2 8 4 16 c 6 10 D 8 6 c 10 4Characteristics of an Isoquant Curve The properties of an isoquant are similar to that of an indifference curve. The following are the important properties of an isoquant curve. 1) lsoquant curve will be downward sloping: The level of output is same along the isoquant curve. Thus, if a firm uses more of one input, it must use less of another input to attain the same level of output. 2) An isoquant curve is convex to the origin: 3) Two isoquant curves cannot intersect each other. Like indifference curves isoquant curves too do not intersect each other. 4) Isoquant Map: A higher isoquant curve gives higher level of outputConvexity The slope of the isoquant curve measures the marginal rate of technical substitution (MRTS) as it shows the rate at which one input can be substituted with another. The slope of isoquant curve diminishes or becomes flatter as we move from point j to m. This implies that we can substitute lesser and lesser amount of K for L as we move down the curve. This is because of the operation of law of diminishing returns. aIsoquant Map In the figure, each isoquant curve reflects a difference level of output. As we move from the original, each successive isoquant curve reflects a higher level of output. This is because at a higher isoquant curve we use more of both L and K, which means more output. Capital a,Expansion Path We know that a rational firm, to maximize its output subject to cost constraint, employs factor inputs in a proportion such that marginal rate of technical substitution (MRTS) is equal to factor price ratio. Given the factor prices, we can get a number of parallel isocost lines by varying the cost constraint. Each isocost line is tangent to one isoquant curve. The locus of all such points of tangencies between the isoquants and isocost lines forms the expansion path of the firm. The points on the expansion path are the most efficient combinations of the two inputs. As all factors of production are variable in the long run, the firm moves along the expansion path to expand its level of output, given the factor prices.