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Production Analysis

Dr.C S Shylajan

Topics of Discussion
The

Organisation of Production

Short

Production

with One Variable Input (Labor) of Diminishing Marginal Productivity

Law

Topics of Discussion
Production

with Two Variable

Inputs
Isoquants
Returns Isocost

to Scale line

Optimum

combination of inputs

Introduction

Now we are looking from supply side. What is to be produced and how to produce it. The theory of the firm will address:
The

basic production decision facing the firm is, how much of the commodity to

That

produce and how much of labour, capital and other inputs to use to produce that output.
How

The Organisation of Production

The

Production Process

Combining Inputs Two

factors of production to achieve an output are the resources that a firm uses in its production process categories of inputs: Fixed inputs and Variable inputs

Short

Labor

(workers, lawyers, doctors, entrepreneurial talent etc)

(natural resources, raw materials etc) Capital (equipments, factories etc)

Materials

Physical

Fixed inputs and Variable inputs

Fixed input: an Input whose quantity can not be changed during the time period under consideration (example: within 1 year) Example: firms plant and specialized equipments, land etc

Variable input: an input whose quantity can be changed easily and on very short notice Example: raw materials, skilled and unskilled labour etc

The Short Run versus the Long Run

Short-run:

Period of time in which quantities of one or more production factors cannot be changed.
Some

The Short Run versus the Long Run

Long-run

A period of time in which all inputs are variable. In the long run, the firm can make a complete adjustment to any change in its environment There will be more input flexibility Factors of production can be substituted

The Production Function

Production
Indicates

Function:

the maximum output of a commodity that a firm can produce with each set of inputs. inputs and outputs are measured in physical rather than in monetary units. firm produces only one type of output (product) with two inputs. Then

Both

Suppose

The production function for two inputs:

Q = F( K, L)
Q = Output,

K = Capital,
L = Labor

Technology is assumed to remain constant The quantity of output is a function of the quantity of labour and capital used in production

The Production Function

Output refers to the number of units of the commodity produced (say, number of automobiles etc) Labour refers to the number of workers employed (number of man-days)

Here Capital refers to the amount of equipments, machinery etc used in production. It is physical capital (machine hours used)

The Production Function with One Variable Input

Thus, we are in the short run. Suppose capital (No of machines for instance) or land is fixed and labour is variable. Then what happens to Total Product (Output) Marginal Product and

Production with One Variable Input (Labor)- An Example

Amount of Labor (L) 0 1 2 3 4 5 6 7 Amount Total of Capital (K) Output (Q) 10 10 10 10 10 10 10 10 10 10 10 0 10 30 60 80 95 108 112 Average Product --10 15 20 Marginal Product --10 20

30

20
19 18 16 14 12 10

20
15 13 4

8
9 10

112
108 100

0
-4 -8

Production with One Variable Input (Labor)

Observations:

1) With additional workers, output increases, reaches a maximum, and then decreases.

Production with One Variable Input (Labor)

Observations:

2) The average product of labor (AP), or output per worker, increases and then decreases.

Production with One Variable Input (Labor)

Observations:

3) The marginal product of labor (MP), or output of the additional worker, increases rapidly initially and then decreases and becomes negative..

Output per Month

D

112

C 60

Total Product

B
A

Total Product increases, reaches maximum and declines

4 5 6 7 8 9 10 Labor per Month

0 1

2 3

Production with One Variable Input (Labor)

Outpu t per Month Observations: Left of E: MP > AP & AP is increasing Right of E: MP < AP & AP is decreasing E: MP = AP & AP is at its maximum

30
Marginal Product

20

Average Product

10

0 1

2 3

5 6

7 8

Observations:
When When When

When

Production with One Variable Input (Labor)

Relation between TP. MP and AP
Output per Month 112 C 60 A 0 1 2 3 4 5 6 7 8 9 10
Labor per Month

Output per Month

30
E

20
10
0 1 2 3 4 5 6 7 8 9 10 per Month
Labor

Production with One Variable Input (Labor)

The Law of Diminishing Marginal Returns

If equal increments of an input are added, the quantities of other inputs held constant, the resulting increments of product will decrease beyond some point, that is, the marginal product of the input will diminish. In our example, beyond 3 units of labour, the Marginal Productivity of labour decreases.

The Law of Diminishing Returns and Stages of Production

Observation: The declining portion of the Marginal Product curve is a reflection of the Law of Diminishing Returns.

This is empirically true.

Because each additional unit of the variable input has less and less of the fixed input to work with.

Production with One Variable Input (Labor) Stages of Production

The relation between the MP and AP curves can be used to define three

stages of production.
Stage

Production with One Variable Input (Labor)

Relation between TP. MP and AP
Output per Month 112 C 60 A 0 1 2 3 4 5 6 7 8 9 10
Labor per Month

Output per Month

30
E

20
10
0 1 2 3 4 5 6 7 8 9 10 per Month
Labor

Stages of Production
Stage

Stage

is negative

Malthus and the Food Crisis

Malthus, a famous economist (17661834), predicted mass hunger and starvation as diminishing returns limited agricultural output and the population continued to grow. But his prediction failed!

Malthus and the Food Crisis

Malthus did not take into consideration the potential impact of technology.

In India, green revolution for instance

In globalised era, impacts of technology is important

The Effect of Technological Improvement

Output per time period

C B

100

O3

Labor productivity can increase if there are improvements in technology, even though any given production process exhibits diminishing returns to labor.

A
50 O2 O1
Labor per time period

0 1

2 3

5 6

7 8

10

Production with Two Variable Inputs- Long Run

In long-run production Captal (K) & Labour (L) are variable inputs.

Factors of production can be substituted

An isoquant is a curve showing all possible combinations of inputs that are capable of producing a certain quantity of output.

Isoquants are used to compare the different combinations of K & L and output.

Isoquants
Factors

of production are substitutable in the long run

level of output with more of one input and less of another input isoquant shows higher output

Same

Higher

Production Function with 2 Variable Inputs

Labor Input Capital Input 1 2 3 4 5

1
2 3 4 5

20
40 55 65 75

40
60 75 85 90

55
75 90 100 105

65
85 100 110 115

75
90 105 115 120

Isoquants

55 units of output is produced with 1 unit of Capital and 3 Units of Labour and 3 units of Capital and 1unit of Labour Similarly, 75 units of output can be produced with different combinations of Capital and and Lobour ( 1K and 5 L), (2K and 3 L), (3 K and 2 L), (5 K and 1 L).

90 Units of output is produced by (2K and 5 L), (3K and 3L), (5K and 2 L).

Capital per year

5
4 3 2

The Isoquant Map

The isoquants are derived from the production function for output of of 55, 75, and 90. Q3 > Q2 > Q1

Q3 = 90 1 1 2 3
D

Q2 = 75 Q1 = 55 4 5
Labor per year

Production with Two Variable Inputs

Substituting

Among Inputs

Managers want to determine what combination of inputs to use. They must deal with the trade-off between inputs. That is, more of one input with less of another input

Production with Two Variable Inputs

Substituting

Among Inputs

The

slope of each isoquant gives the trade-off between two inputs while keeping output constant.

Rate of technical Substitution

The slope of an isoquant is called the marginal rate of technical substitution (MRTS). MRTS is the amount by which one input can be reduced when one unit of another input is added. It is the rate that capital can be reduced, holding output constant, while using one more unit of labor

Capital per year

5
2

1 1

1 2/3 1 1/3 1

The marginal rate of technical substitution equals:

MRTS - Change in capital/Ch ange in labor input

MRTS K

Farmers

Isoquant Describing the Production of Wheat

Capital (machine hour per year) 120
Point A is more capital-intensive, and B is more labor-intensive.

A
K - 10
L 260

100 90 80

B
Output per year

40

250

500

760

Isoquant Describing the Production of Wheat

Observations:

1) Operating at A:

Isoquant Describing the Production of Wheat

Observations: 2) Operating at B

Increase L to 760 and decrease K to 90 the MRTS < 1:

L (10 / 260 ) 0 .04

MRTS - K

Isoquant Describing the Production of Wheat

Observations:
3) The cost of labor must be less than

capital in order for the farmer substitute labor for capital

4) If labor is expensive, the farmer would use more capital. 5) If labor is inexpensive, the farmer may use more labor (e.g. India).

Returns to Scale

Measuring the relationship between the scale (size) of a firm and output

Returns

to scale is the rate at which output increases in response to proportional increases in all inputs.
doubling of inputs permits a greater division of labor allowing persons to specialize in the production

Returns to Scale
There

returns to Scale

Increasing

Constant

Decreasing

1)

Larger

output associated with lower cost

in the use of labor and

Specialization

capital

Returns to Scale
Capital (machine hours)

Increasing Returns

4 30

2
10 0 5 10

20

Labor (hours)

Returns to Scale
2) Constant returns to scale: Output doubles when all inputs are doubled

Size

Isoquants

are equidistant apart

Returns to Scale
Capital (machine hours)

Constant Returns A 6

30
4 20 2 10

10

15
Labor (hours)

Returns to Scale
3) Decreasing returns to scale:

Decreasing

efficiency with large size

Management Managing

large number of employees becomes

difficult

Returns to Scale
Capital
Decreasing Returns to Scale A

15
2

10
0 5 10

Labour

Using

Time Series Data

Take year-wise data (1980 2008 for instance) on various inputs employed to produce output in different years and estimate it using regression analysis
Using

Cross-section Data

Take data on various inputs employed and output produced in various firms at a given year (2008 for instance) and estimate the production function

Choice of Optimal Input Combination

Overview

Decisions regarding input combinations Isocost Line Optimal Combination of inputs and Maximisation of Output for a given cost

Expansion Path

Decisions regarding input combinations

How a profit maximising firm will combine inputs to produce a given quantity of output? Suppose there are two inputs, Capital and Labour. What combination of capital and labour should the firm choose if it wants to maximize the quantity of output derived from the given level of cost?

Isocost Line
First

determine the various combinations of inputs that the firm can obtain for a given expenditure. line shows the various combinations of inputs that a firm can purchase for a given expenditure. that a firm uses only Labour and Capital in production.

Isocost

Suppose

Isocost Line

Then total expenditure of the firm can be represented by

C=PL L + Pk K
Where C = total costs PL = Price of labour per unit

is expenditure on Labour is expenditure on Capital

PL L

(wage rate)
L = Amount of labour used Pk = Price of capital per unit K = Amount of capital input used

Pk K

Isocost Line PL L + P k K = C
firms isocost line.

is equation of the

It shows the various combinations of labour and capital that the firm can hire at a given total cost. Suppose firm is ready to spend \$100
Price of labour input = \$ 10 Price of Capital input = \$10

10 (6 units of L) + 10 (4 units of K) = 100

is one combination

Isocost Line or Equal cost curve

10 Capital 8 6 4 2 0 2 4 6 8

Isocost line

10 Labour

Shift in Isocost Line due to increase in Budget of the firm

20 New Isocost line Given the unit prices of inputs remain constant and if the budget increases, isocost line shifts outward. C= \$200 2 0 2 4 6 8 10 Labour 20

10 Capital 8 6 4 C=\$100

Suppose price of labour input decreases

10 Capital 8 6 4 2 0 2

New Isocost line

10 Labour

Budget remains same

10 Capital 8 6 4 2 0 2 4 6 8 10 Labour New Isocost line

Optimal Input Combination for Maximising

Output
By

using isocosts and isoquants, we determine the optimal input combinations for the firm to maximise output.

The

optimal combination of inputs is determined at the tangency point of an isoquant and an isocost.

Maximisation of Output for a given cost

Isoquant 10 Capital 8 6 Isocost line 4 2 0 2 4 6 8 A Optimal Combination Of inputs

8Q

10Q

10 Labour

The firm should choose an input combination for which

MPL

MPk

PL
That

Pk

is, the ratio of marginal product to input price be equal for all inputs.

Condition for the optimal combination of inputs

Where

MPL is marginal product of labour MPk is marginal product of Capital PL is price of labour per unit Pk is price of Capital input per unit

An Example
Suppose

a firm decides to spend \$200 on two inputs Labour and Capital. of Labour is \$10 per unit

Price

Price
What

combination of inputs is optimal?

An Example

First we have to calculate the marginal products of two inputs,Capital and Labour
Compute the ratio of marginal product to input price for both Capital and Labour. Given the expenditure constraint,(\$200), which input combination meets the condition for optimal input combination, that is the ratio of marginal products to input prices be equal for both inputs, Capital and Labour.

Condition for the optimal combination of inputs Amt of MP of MPL/PL Amt of MP of MPk/Pk Labour Labour Capital Capital 2 20 2 9 4 0.2 4 18 1.8 8 6 0.3 6 16 1.6 7 8 0.4 8 14 1.4 6 10 0.5 10 12 1.2 5 12 0.6 12 10 1 4 14 0.7 14 3 8 0.8 16 0.8 16 6 0.6 2 18 0.9 18 4 0.4 1 20 1

Optimal input combination

The firm should choose an input combination for which MPL/PL = MPk/Pk Optimal input combination is 14 Units of Labour and 3 Units of Capital. 14 (\$10) + 3 (\$20) =\$200

Expansion Path of the firm

The

firms expansion path is the set of cost-minimizing input combinations a firm will choose to produce various levels of output (when the prices of inputs are held constant).

Expansion Path- Graphically

The Expansion Path 10 Capital 8 6 4 2 0 2 4 C=\$200 6 8 A 20Q

10Q
C=\$400 10 Labour

Summary
A

production function describes the maximum output a firm can produce for each specified combination of inputs. isoquant is a curve that shows all combinations of inputs that yield a given level of output.

An

Summary
Average

product of labor measures the productivity of the average worker. product of labor measures the productivity of the last worker added.

Marginal

Summary

The law of diminishing returns explains that the marginal product of an input eventually diminishes as its quantity is increased. In long-run analysis, we focus on the firms choice of its scale or size of operation.

Quiz Time
The

marginal product of a variable input is best described as

(a) Total product divided by the number of units of variable input.

(b) The additional output resulting from a one unit increase in the variable input.
(c) The additional output resulting from a one unit increase in both the variable and fixed inputs. (d) The ratio of the amount of the variable input that is being used to the amount of the fixed input that is being used.

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