Production Analysis

Business Economics
Faculty: Sunitha Raju

Production Analysis - I
Session Date:19.10.2013
EPGDIB 2013-15
Business Economics/ Session: 6
Decision Problem
what is the most efficient and cheapest means of producing quantities of
output demanded by consumers

Efficient Production Decisions
- understanding the fundamentals of Production functions and
Production process
- selection of Production technique and resource inputs
- Relationship between technology, inputs and output

Contd
Economics of Production Decisions
EPGDIB 2013-15
1. Defining Production Function

Production is physical transformation of input resources into
goods & services

Inputs Process Output

Production function defines the technical relationship
between production inputs and output
Basic Production Concepts
Contd
EPGDIB 2013-15
2. Defining Production Process

A product can be produced by various techniques/methods of
production

A method in which various inputs are combined is defined by a
Process or Technique (P)

P1 P2 P3
L 2 3 5

K 3 2 4
Output is same but methods of input combination differs.
Contd
EPGDIB 2013-15
Technically efficient process

P1 P2
L 2 3

K 3 3
P1 is technically efficient as less L used compared to P2

P1 P2
L 2 1

K 3 4

P1 and P2 are not comparable and both considered as
technically efficient

Contd
EPGDIB 2013-15
Economic Efficient process
Amongst the technically efficient processes, the least cost
process is defined as Economically efficient process.
Contd
EPGDIB 2013-15
3. Inputs

Based on relationship with output, broadly categorise all inputs
into

Fixed inputs (Capital) : same level of input irrespective of
output level (eg : Machinery)

Variable input (Labour) : Varies with output level
Q= f (L, K)

how do changes in input level influence the changes in
output level

Contd
EPGDIB 2013-15
4. Long Run vs Short Run

Short run

When Production decisions are defined by a given
capacity/capital/technology

Fixed and variable inputs together production determine
production.

decision relates to how much to produce under a given
capacity

Contd
EPGDIB 2013-15
Long run

When Production decisions are not constrained by a given
technology/capacity

Number of technological options exist. As such, no fixed inputs

Production decision relates to identifying optimum capacity/scale
of operation.

EPGDIB 2013-15
Short Run Production Function

A production function defines all technical efficient input-output
combinations

Any improvement in technology results in new production function.

eg: better equipment, productivity enhancing training

EPGDIB 2013-15
Short Run Production Decisions
1. Case of one variable input

a) Decision on output/input level
b) defining technically efficient level of output
c) defining economically efficient level of output

Together (a), (b) & (c) will determine how much output (Q)
to produce and how much inputs to use.

Q = f (L, K )
EPGDIB 2013-15
ABC Company: Average and
Marginal Products of Labour
Amount of Machine Tools
(Fixed) (K)
Amount of Labour (L) Total Output
5 0 0
5 1 12
5 2 27
5 3 42
5 4 56
5 5 68
5 6 76
5 7 76
5 8 74
EPGDIB 2013-15
ABC Company: Average and
Marginal Products of Labour
Amount of
Machine Tools
(Fixed)
Amount of
Labour
Total
Output
Average
Products of
Labour
Marginal
Product of
Labour
MRP
L
5 0 0 - - -
5 1 12 12.0 12 60
5 2 27 13.5 15 75
5 3 42 14.0 15 75
5 4 56 14.0 14 70
5 5 68 13.6 12 60
5 6 76 12.7 8 40
5 7 76 10.9 0
5 8 74 9.2 -2
Assume MR = 5
P
L
= 60
EPGDIB 2013-15
Decision on how much Q to produce
As long as MP
L
is positive
Marginal Revenue Product (MRP
L
)
MRP
L
= P
L

= MRP
L
=

= MR
L
. MP
L
= P
L

Corresponds to
Q = 68 and L = 5
L
P
L
Q
Q
TR
=
D
D
D
D
.
EPGDIB 2013-15
Problem Solving 1
Tax Advisors Inc. has an office for processing tax returns in Pennsylvania. The
following table shows how many tax returns are processed per hour as the
number of CPA (Certified Public Accountants) employed increases
CPAs (L) Tax returns processed / hour
1 0.2
2 1.0
3 2.4
4 2.8
5 3.0
6 2.7
1. Should the firm engage the 4
th
CPA? What should be the optimum number
of CPAs to be engaged?

2. If the CPAs earn $35 per hour and the revenue for each tax return processed
is $100, should the firm employ the 4
th
CPA.
EPGDIB 2013-15
1. Given a production function

Under conditions of recession (output prices are falling), a firm
decides to produce where AP
L
max

Under conditions of boom (output prices are rising), a firm
produces until MRP
L
PL

Conceptualize the rising managerial salaries
Production Decisions : Dimensions
Contd
EPGDIB 2013-15
2. Case of more than one variable input

Efficient combination of inputs

Methodology used is Isoquant

Production Decisions : Dimensions
EPGDIB 2013-15
Isoquants
2 3 4 5 6
1
2
3
4
5
L
1
L
2
3
1
7
10
12
6
12
10
8
18
23
28
28
24
12
28
33
36
36
31
14
30
36
40
40
42
12
28
33
36
40
39
Isoquants show combination of two inputs that can produce
same level of outputs
Short run Production Function : Efficient
Combination of Inputs
EPGDIB 2013-15
Isoquants

2 3 4 5
1
2
3
4
5
L
1
L
2
3
1
7
10
12
6
12
10
8
18
23
24
12
33
31
14
30
40
40
42
12
33
36
40
39
28
28
28 28
36
36
36
Isoquants show combinations of two inputs that can produce
same level of outputs
EPGDIB 2013-15

Substitution between L
1
and L
2
is determined by marginal productivities of L
1
and L
2

Marginal rate of technical substitution
(MRTS) = =

The rate of substitutability between inputs is defined by the shape of Isoquant (ratio of MP
L
)
L
1
L
2
Q
1
Q
2
Q
3
2
1
L
L
D
D
1
2
MPL
MPL
EPGDIB 2013-15
Isoquant
L
1
L
1
L
1
L
1
and L
2
are not
perfect substitutes
L
2
L
2
L
2
L
1
and L
2
are perfect
substitutes
L
1
and L
2
are
complementary
EPGDIB 2013-15
Isocost
Isocost show the different combinations of inputs (at given
prices) For the same cost outlay.

L
1
L
2
Any point on Isocost reflects the price ratio of L
1
and L
2
EPGDIB 2013-15
Efficient Combination of Inputs

.
1
2
L
L
P
P
MRTS =
1
1
1
1 2
1
2
1
L
L
L
L
L
L
L
L
P
MP
P
MP
P
P
MP
MP
= = =
EPGDIB 2013-15
Efficient Combination of inputs
Effect of a change in Input Price

Q
2
L
1
L
2 L
2
L
2
L
1
L
1
EPGDIB 2013-15
Problem Solving
Medical Testing Labs, Inc., provides routine testing services for
blood banks in the Los Angeles area. Tests are supervised by skilled
technicians using equipment produced by two leading competitors in
the medical equipment industry. Records for the current year show
an average of 27 tests per hour being performed on the Test logic-1
and 48 tests per hour on a new machine, the Accutest-3. The
Testlogic-1 is leased for $18,000 per month and the Accutest-3 is
leased at $32,000 per month. On average, each Machine is operated
25 days of 8 hours each.

1. Does the Lab usage reflect optimal mix of Testlogic-1 and Accutest-3.

2. If the price of tests conducted at the Lab is $6, should the company
lease more machines.

EPGDIB 2013-15
Long Run Production Function
Scale of operation is another source for cost minimization

Identifying optimal scale of operation for a given demand
conditions
EPGDIB 2013-15
Long run Production Function
Q = f (L, K)
Where scale increases, then
output increases (Increasing Returns to Scale)
by a greater proportion

output increases (Constant Returns to Scale)
by the same proportion

output increases (Decreasing Returns to Scale)
by a lesser proportion
EPGDIB 2013-15
Production Function Q = f(L, K)
Q = f (hL, hK)
If = h, then f has constant returns to scale.
If > h, then f has increasing returns to scale.
If < h, the f has decreasing returns to scale.

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Business Economics

Faculty: Sunitha Raju

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