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PRODUCTION ANALYSIS

INTRODUCTION
Production is basically an activity of transformation which
transfers inputs into outputs.
Farms use land, labor, seeds and small amount of capital as
inputs to produce output like corn.
Similarly, a flour mill uses inputs like wheat, labor, capital
for machinery, factory building to produce output like wheat
flour.
So, an input is the goods or services which produce an
output.
The firm generally uses many inputs to produce an output.
Output of any firm may be the inputs of other firms, e.g.,
steel is an output of the steel producer, but this steel is also
an input of automobile or rail coach manufacturing or
refrigeration manufacturing or air-condition manufacturing
industries.
PRODUCTION ANALYSIS

The transforming process of inputs into output can be three


types:
i) change in form (output should be new form compared to
inputs, for example cloth as output and thread as input)
ii) change in space (transportation)
iii) change in time (storage).
The transformation process or production increases the
consumer usability of goods and services.
PRODUCTION ANALYSIS
Production Function
A production function is the technical relationship between
inputs and outputs.
A commodity may be produced by various methods using
different combinations of inputs with given state of
technology.
Take the example of cloth, it may be produced by using
cotton or silk or polymer as raw materials with handloom,
power loom or computerized machines.
You can see various types of raw materials and technology
options will create several possible ways of producing the
same product.
Hence, there can be several technically efficient methods
of production.
PRODUCTION ANALYSIS
Production function shows the maximum quantity of the
commodity that can be produced per unit of time for each
set of alternatives inputs, and with a given level of
production technology.
A given amount of output can be produced by different
combinations of inputs and each of these combinations may
be technically efficient.
Technical efficiency is defined as a situation when using
more of one input with either the same amount or more of
the other input must increase output.
Normally a production function is written as;
Q = f (x1, x2,...xn) .(i)
Where, Q is maximum quantity of output of a good being
produced, and x1, x2,...xn are the quantities of various
inputs used in production.
PRODUCTION ANALYSIS
If we replace x1, x2,...xn in (i) by the factors of production
discussed above, then the production function may be;
Q = f (L, K, I, R, E) .. (ii)
Where, Q =output and the inputs are L, K, I, R, E; L=
labour, K = capital, I =land, R =raw material and E =
efficiency parameter.
In short run, some inputs like plant-size, and machine
equipments cannot be changed, so a producer trying to
increase output in the short run will have to do so by
increasing only the variable inputs.
On the contrary in the long run input options are very wide.
On the basis of such characteristics of inputs, production
functions are normally divided into two broad categories:
(i) with one variable input or variable proportion production
function
(ii) with two variable inputs or constant proportion
production function
PRODUCTION ANALYSIS
PRODUCTION FUNCTION WITH ONE VARIABLE INPUT
In short run, producers have to optimize with only one
variable input.
Let us consider a situation in which there are two inputs,
capital and labour, capital is fixed and labour is variable
input.
You will notice as the amount of capital is kept constant and
labour is increased to increase output, the ratio in which
these two inputs are used will also change.
Therefore, any change in output can be manifested only
through a change in labour input only.
Such a production function is also termed as variable
proportion production function; it is essentially a short term
production function in which production is planned with
variable input.
PRODUCTION ANALYSIS
The short run production function shows the maximum output a firm
can produce when only one of its inputs can be varied, other inputs
remaining fixed. It can be written as:
Q = f (L, K0)..(iii)
Where, Q is output, L is labor and K0 denotes the fixed capital.
This also implies that it is possible to substitute some of the capital by
labor.
It is easy to understand that as units of the variable input are
increased, the proportion of use between fixed input and variable input
also changes.
Therefore, short run production function is governed by law of
variable proportions.
To explain the concepts of average and marginal products of factor
inputs consider the production function given in equation (iii),
assuming capital to be constant and labor to be variable, total product
is a function of labor and is given as:
TPL = f (K0, L)..(iv)
PRODUCTION ANALYSIS

Q
Q3 = f (K30, L)

Q2 = f (K20, L)

Q1 = f (K10, L)

L
Production Function with constant K; K10< K20< K30
PRODUCTION ANALYSIS
If instead labour is fixed in the short run, the total product of
the capital function can be similarly expressed as:
TPK = f (L0, K) .(v)

Q
Q3 = f (L30, K)

Q2 = f (L20, K)

Q1 = f (L10, K)

K
Production Function with constant L; L10< L20< L30
PRODUCTION ANALYSIS

Average Product (AP) is total product per unit of variable


input; therefore it can be expressed as:
APL = TP / L..(vi)
If instead of capital, labor is fixed in the short run, average
product of the capital function (APK) can be similarly
expressed as:
APK = TP / K..(vii)
Marginal Product (MP) is defined as addition in total output
per unit change in variable input.
Thus marginal product of labor (MPL) would be:
MPL = dTP / dL .(viii)
PRODUCTION ANALYSIS
PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS
Most simplistic form of production function with two
variable inputs, labour (L) and capital (K), and a single
output, Q, is as follows;
Q = f (L, K) .(ix)
This production function is constructed based on the
assumption that the state of the technology is given and
output can be increased by increasing inputs.
When the state of technology changes, the production
function itself changes.
Further, it is assumed that the inputs are utilized in the best
possible way, i.e., optimum utilization of inputs.
The best utilization of any particular input combination is a
technical, not an economic problem.
Selection of best input combination for the production of a
particular output level depends upon the input and output
prices and is subject of economic analysis.
PRODUCTION ANALYSIS

LAW OF VARIABLE PROPORTION OR LAW OF


DIMINISHING RETURNS TO FACTORS
The slope of the total product curve is determined from the
law of diminishing returns.
The law of diminishing returns, being empirical in nature,
states that with a given state of technology if the quantity of
one factor input increased, by equal increments, the
quantities of other factor inputs remaining fixed, the
resulting increment of total product will first increase and
then decrease after a particular point.
The law is also known as diminishing returns to factors.
It states that as more and more one factor of production is
employed, other factor remaining the same, its marginal
productivity will diminishing after some time.
PRODUCTION ANALYSIS

For example, if we increase labor input and capital input


remaining the same, then the marginal productivity of labor
first increased, reaches maximum and then decreases.
The law of diminishing returns to factors is depending on
three assumptions.
i) It is assumed that the state of technology is given.
ii) It is assumed that one factor of production must always
be kept constant at certain level.
iii) This law is not applicable when two inputs are used in a
fixed proportion and the law is applicable only to varying
ratios between the two inputs.
PRODUCTION ANALYSIS

DIFFERENCE BETWEEN RETURNS TO A FACTOR AND


RETURNS TO SCALE
The law of diminishing returns factors states that as more
and more one factor of production is employed, other
factor remaining the same, its marginal productivity will
diminishing after some time, e.g., if we increase one factor
of production i.e., labour and other factor of production
i.e., capital remaining the same, then the marginal
productivity of labour first increased, reaches maximum
and then decreases.
So, returns to a factor (variable factor) of production is first
increasing in the initial level of production and then
decreasing if we increase the amount of that variable factor
of production.
PRODUCTION ANALYSIS

But, if we increase more and more of that variable factor


then the returns to the variable factor is negative.
In the very first stage of production, if additional units of
labour are employed, the total output increases more than
proportionately; so marginal product rises.
In the following figure, stage I would begin from the origin
and continue to a point where APL attains its maximum
value.
In this stage, MPL > 0, and MPL > APL. This stage is called
as increasing returns to the variable factor.
PRODUCTION ANALYSIS

TP

TPL

L
TP

Stage I Stage II Stage III

APL

MPL

O L
TP, AP and MP Curves
PRODUCTION ANALYSIS
In the second stage, the total product increases but less
than proportionate to increase in labor.
In this stage, marginal product of labor falls and this stage
is called as diminishing returns to variable factors. Here,
MPL > 0 and MPL < APL.
The stage three is a technically inefficient stage of
production and a rational producer will never produce in
this stage. Here, MPL < 0 and total product is decreasing.
The law of returns to scale refers to the long run
analysis of production.
It refers to the effects of scale relationships which implies
that in the long run output can be increased by changing
all factors by the same proportion, or by different
proportions.
If the production function is Q0 = f (K, L) and we increase
all the factors of production by the same proportion p.
PRODUCTION ANALYSIS
So, the new production function is Q* = f [(p.K), (p.L)].
If Q* increases in the same proportion as the factors of production,
p, then we can say there are Constant Returns to Scale (CRS).
If Q* increases less than proportionately with an increase in the
factors of production, p, then we can say there are Decreasing
Returns to Scale (DRS).
If Q* increases more than proportionately with an increase in the
factors of production, p, then we can say there are Increasing
Returns to Scale (IRS).
Q IRS

CRS

DRS

Proportion (p)
O
Returns to Scale (DRS, CRS & IRS