LONG RUN PRODUCTION FUNCTION

MBA (PM)

What Is Production
Function
Production

function deals with the
maximum output that can be
produced with a limited and
given quantity of inputs.

PRODUCTION FUNCTION
1.The tool of analysis used to explain the inputoutput relationship
2.Describes the technological relationship
between inputs and outputs in physical terms
3.It tells that the production of a commodity
depends on specific inputs
4.It represents quantitative relationship between
inputs and output
5.It represents the technology of a firm, of an
industry, or of the economy as a whole

Production Function
Mathematical

representation
of the relationship:
Q = f (K, L, La)
Output (Q) is dependent upon
the amount of capital (K), Land
(L) and Labour (La) used

ASSUMPTIONS
THE PRODUCTION FUNCTIONS ARE BASED ON
CERTAIN ASSUMPTIONS
1. Perfect divisibility of both inputs
and outputs
2. Limited substitution of one factor
for another
3. Constant technology
4. Inelastic supply of fixed factors in
the short run

THE LAWS OF PRODUCTION
LAWS OF VARIABLE
PROPORTIONS

LAWS OF RETURNS
TO SCALE

Relates to the study
of input output
relationship in the
short run with one
variable input while
other inputs are
held constant

Relates to the study
of input output
relationship in the
long run assuming
all inputs to be
variable

What is long run production
function ?
 Long

run refers to that time in the
future when all inputs are variable
inputs.


 In

the long run both capital and
labour are included

 Output

can be varied by changing
the levels of both L & K and the
long run production function is
expressed as:

THE LAW OF RETURNS TO SCALE

EXPLAINED BY

ISOQUANT
CURVE
TECHNIQUE

PRODUCTION
FUNCTION

LONG RUN TOTAL PRODUCTIONReturns to scale

 During

the short period, some factors of
production are relatively scarce, therefore ,
the proportion of the factors may be
changed but not their scale. But in the long
run, all factors are variable, therefore, the
scale of production can be changed in the
long run


 Returns

to scale is a factor that is studied in
the long run.

Returns to Scale
When

all inputs are changed in the
same proportion (or scale of
production is changed),the total
product may respond in three
possible ways:
1)Increasing returns to scale
2)Constant returns to scale, and
3)Diminishing returns to scale

INCREASING RETURNS TO SCALE
 The

law of increasing
returns to scale operates
when the percentage
increase in the total
product is more than the
percentage increase in all
the factor inputs employed
in the same proportion.
 Many economies set in and
increase in return is more
than increase in factors.
 For e.g 10 percent increase
in labour and capital
causes 20 percent
increase in total output.
Similarly, 20 percent
increase in labour and

CONSTANT RETURNS TO SCALE
 Law

of constant
returns to scale
operates when a
given percentage
increase in the
factor inputs in the
same proportion
causes equal
percentage
increase in total
output.

 Economies

of scale
are counter
balanced by
diseconomies of

DIMINISHING RETURNS TO
SCALE
The law of
diminishing
returns to scale
occurs when a
given percentage
increase in all
factor inputs in
equal proportion
causes less than
percentage
increase in output.

Output

increases in a
smaller

Graphically , the returns to scale
concept can be illustrated using
the following graphs

Q

IRTS

Q

X,Y

Q

CRTS

X,Y

DRTS

X,Y

ADVANTAGES AND DISADVANTAGES OF LARGE SCALE PRODUCTION

Specialization

Rent

Economy of
labour

Overhead
charges

Economics of
buying and
selling

Reduction in costs when the
scale of production
increases is called
ECONOMIES OF
SCALE

INTERNAL
ECONOMIES

EXTERNAL
ECONOMIES

INTERNAL ECONOMIES
Technologic
al
Economies
in
Production

Economies
in
Marketing

Large scale production
provides opportunities for
technological advances

Advantages
Advantages of

Large scale production
workers of varying skills &
qualifications are employed
which facilitates division
of labour as per
specialization

divisions of
labour
.. Large scale
selling& of firms
own products
Specialization
.. Large scale
purchase of raw
materials & other
inputs
.. Advertising
cost
.. Large

scale
distribution

Improves the overall
performance of the
firm

.. Specialization
in managerial
activities
Managerial
Economies

Transport
&
Storage
Economies

.. Mechanization
of managerial
functions

.. Efficient
management of the
transport
function

.. Proper
utilization of
storage
facilities

.. Improves
managerial
efficiency

.. Helps in
reducing
transportation
and storage costs

CAUSES OF INTERNAL ECONOMIES

SIZE

Big
Machine

LIMITING
PROCESS

Mergers

TECHNIQUE

Superior
Technique

SPECIALI ZATION

Division of
Labour

Bigger capacity
lower Energy
less labou

Spreading of
costs

Shorter period
of time

Increase in
efficiency

MANAGERIAL
ECONOMICS

Aggregation

Financial
economies

Managerial
economies

Credit facilities

COMMERCIAL
ECONOMIES
Wide Market

RISK BEARING
ECONOMIES

Diversification

Encourages
investment

Spreading
Risks

CAUSES OF EXTERNAL ECONOMIES
CONCENTRATION

Advantage
s

of
locality

INFORMATION

Knowledge
sharing

DISINTEGRATION

Breaking
up

Common Pool of
Knowledge
of locality

Reduced
transportation cost
The benefits which
companies derive
from trade
publications and
technical journals
By virtue of
location , common
pool of research
can be created and
benefits can be
shared
Breaking up of
processes which can
be handled by
specialist firms

Production Isoquants /
isoquant curve / iso - product
curve
In the long run, all inputs are
variable & isoquants are used to
study production decisions
–An isoquant or iso-product curve is a
curve showing all possible input
combinations capable of producing a
given level of output
–Isoquants are downward sloping; if
greater amounts of labor are used,
less capital is required to produce
a given output
22

ASSUMPTIONS
1.THERE ARE ONLY TWO FACTORS
OF PRODUCTION…CAPITAL (K)
AND LABOUR (L) TO PRODUCE
A COMMODITY X
2.THE TWO FACTORS CAN
SUBSTITUTE EACH OTHER UP
TO A CERTAIN LIMIT
3.THE TECHNOLOGY IS GIVEN
OVER A PERIOD

Example Isoquant
Curve

º2,6
º3,4
º4,3
º6,2
º8,2

of

7
capital
6
Isoquant; TP = 100 units
5
4
3
2
1
0 Units
of
Labour

Units of Y

The following
combinations of
Units
inputs X and Y
produce 100
units of output:

0

2

4

6

8

Isoquant curve for 100
units of output

PROPERTIES:1.Slopes downward towards
right
2.Convex to the origin point
because of diminishing
marginal rate of technical
substitution (MRTS)

A

K4

3.

B

K3

Units of K

MRTS =

change in capital
change in labour

Two iso-product curves do
not cut each other

C

K2

D

K1

Iq1 = 100
0
L1

L2

L3
Units of L

L4

ISOQUANT

MAP -

A family or a
group of isoquants is called an
ISOQUANT MAP

A

Units of K

K4

Iq4 = 400

B

K3

Iq3
C

K2

D

K1

0
L1

L2

L4

L3
Units of L

= 300

Iq2

= 200

Iq1
100

=

The Isocost Line
Capital, K (machines
rented)

A

a

10

b

8

c

6

Cost = Rs50
Per unit price
of labor input
= Rs10/hour
Per unit price
of capital
input =
Rs5/machine
d

4

e

2

f
0
7

B3
1
2
4
5
8
9
10 employed)
Labor,
L (worker-hours

6
27

Slope of isocost
M=P .Qline
+P .Q

L

L

K

K

Where, M=total outlay

PL= price per unit of labor

QK= price per unit of capital

QL= units of labor

QK= units of capital

Slope of isocost line= OA/OF


price per unit of labour
=−
price per unit of capital

input
input

Slope of isocost line can be change in two ways:
1)Change in the factor price, and
2)Change in total outlay or total cost

Price

Capital, K (machines rented)

Decrease in the factor price causes rightward
shift and increase in factor price causes
leftward shift in iso-cost line.
Cost = 500; labor,R = 16.5 or 10or 1/ hour
The money wage, W = Rs5/machine

a
10
8
6

A Change
in unit price of labor

4
…Rs10

2
Rs16.5

6

0

h

f

…Rs1

1
2
3
4
7 L (worker-hours
8
9 employed)
10
Labor,

5
29

K

Change in total outlay or total cost

Un
it
s

Direction of increase
in total cost

Slope = - w / r

of

TC= Rs. 100
TC= Rs. 75
ca
pi
ta
l
(r
)

TC=Rs. 50

Units

labour ( w )

of

L

30

Isoquants and Cost Minimization
K
0

IQ
3

IQ 2

Un
it
s
of

2

Ca
p[
it
al 4

M

IQ
1

N

P

P”

TC=Rs10
0
TC=Rs=75

6


TC=Rs50

Q=300
Q=200

P’

8

Q=100
0

10

16

2

18

4

6

20
Units of
Labour

8

10

12

L
14
31

Optimization & Cost

Expansion path gives the
efficient (least-cost) input
combinations of labor and capital
needed foe every levels of output.
üDerived for a specific set of input
prices
üAlong expansion path, input-price ratio
is constant & equal to the marginal
rate of technical substitution
It is defined as the locus of tangency
points between iso-cost lines and
isoquants.

32

EXPANSION PATH
It

Capital input

implies to Long run
because:
üNo input is fixed.
üPath starts from
origin indicating that
if output is zero
costs are zero .
Expansion path gives us
the
level of output & one
least
combination that can
produce this level of
output.
Movement along the line
gives
the costs at which output
can

Labor input

ISOQUANTS AND RETURNS
TOSCALE
INCREASING RETURNS TO SCALE
0E>EE1>EE2

CONSTANT RETURNS TO
SCALE

EE1=EE2=EE3

DIMINISHNING RETURNS TO
SCALE

0E<EE1<EE2

The LR Relationship Between
Production
and Cost
 In the long run, all inputs are variable.
◦ What makes up LRAC?

Long run average cost
LR A C re fe rs to

minimum possible per
unit cost
of producing
different quantities
of output of
a good in the long
period.
SRAC curves represent
various plant sizes
Once a plant size is
chosen, per-unit
production costs are
found by moving along
that particular SRAC
curve

LRAC is made up of SRACs . Since
LRAC envelopes all short run
curves , hence Called ENVELOPE
CURVE

Envelope curve
LRAC can never cut SRAC but it will be
tangential to each SRAC at some point.
Average cost can not be higher in the
long run than in the short run;
Explanation;
1.Any adjustment which will reduce costs
possible to be made in the short run
must also be possible in the long run
2.It is not always possible in the short
run to produce a given output in the
cheapest possible way as all the factors
are not variable.

Long run average cost
properties
curve
vU-shaped curve.

vBased on assumption of
unchanging technology.
Minimum
efficient
scale
vLRAC
is flatter
curve than
the is the lowest output leve
SRAC.
qIn economics ,we define long
period as that during which size
of the organization can be
altered to meet changed
conditions.
vNormally;
qOutput increases and average
costs also increases
qBut in long run, size of the
firm Can be
increased
therefore Variable costs are
likely to rise less sharply. Hence
a flatter curve.

The Long - Run Cost Function
Reasons for Economies of Scale…
üIncreasing returns to scale
üSpecialization in the use of labor
and capital
Economies in maintaining inventory
Discounts from bulk purchases
Lower cost of raising capital funds
Spreading promotional and R&D costs

üManagement efficiencies

The Long - Run Cost Function
Reasons for Diseconomies of Scale…
üDecreasing returns to scale
üInput market imperfections e.g. wage rate
driven up
üManagement coordination and control
üproblems
üDisproportionate rise in transportation costs
üDisproportionate rise in staff and indirect
labour

Application of the
concept
In

the long run, a firm exercises its
choice
with regard to the size of the plant
and
scale of production, on the basis of
long run
average cost.
Selection of the optimal plant size
according
to the expected demand.
Avoid unnecessary costs due to

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