PRODUCTION ANALYSIS

Production
 States the relationship between inputs and outputs
 Inputs – the factors of production classified as:
 Land – all natural resources of the earth –Price paid to
acquire land = Rent
 Labour – all physical and mental human effort involved
in production
 Price paid to labour = Wages

 Capital – buildings, machinery and equipment

not used for its own sake but for the contribution
it makes to production
 Price paid for capital = Interest
Production Decisions of a Firm

1. Production Technology
 Describe how inputs can be transformed into
outputs
 Inputs: land, labor, capital & raw materials
 Outputs: cars, desks, books, etc.
 Firms can produce different amounts of outputs
using different combinations of inputs
2. Cost Constraints
 Firms must consider prices of labor, capital and
other inputs
 Firms want to minimize total production costs partly
determined by input prices
 As consumers must consider budget constraints,
firms must be concerned about costs of production
3. Input Choices
 Given input prices and production technology, the
firm must choose how much of each input to use in
producing output
 Given prices of different inputs, the firm may choose
different combinations of inputs to minimize costs
 If labor is cheap, may choose to produce with
more labor and less capital
PRODUCTION FUNCTION

 The production function for two inputs:

q = F(K,L)
 Output (q) is a function of capital (K) and Labor (L)
 The production function is true for a given technology
 If technology increases, more output can be

produced for a given level of inputs

Production Function

INPUT PROCESS OUTPUT

LAND
Product or
LABOR
service
CAPITAL generated
– value added
 Production function with constant K

output

Q=F(L,K0)

LABOUR
AVERAGE AND MARGINAL
PRODUCTIVITY
 Average product of Labor - Output per unit of a particular
product
Measures the productivity of a firm’s labor in terms of
how much, on average, each worker can produce
Output q
AP = =
Labor Input L

 Marginal Product of Labor – additional output

produced when labor increases by one unit
Change in output divided by the change in labor
∆Output ∆q
MP L = =
∆Labor Input ∆L
TOTAL PRODUCTIVITY

1. When labor is zero, output

is zero as well
2. With additional workers,
output (q) increases up to
8 units of labor.
3. Beyond this point, output
declines
 Increasing labor can make better
use of existing capital initially
 After a point, more labor is not
useful and can be
counterproductive
Analysis of Production Function:
Short Run
 In the short run at least one factor fixed in supply but all
other factors capable of being changed
 Can increase or decrease output using more or less of
some factors but some likely to be easier to change than
others
 Increase in total capacity only possible
in the long run
SHORT RUN ANALYSIS

 We will begin looking at the short run when only one

input can be varied
 We assume capital is fixed and labor is variable
 Output can only be increased by increasing labor
 Must know how output changes as the amount of
labor is changed
The Law of Variable Proportion

The law of variable proportion states that as we go on

employing more of one factor of production other factor
constant, its marginal productivity will diminishes after
some point
Assumptions
 Firstly ,state of technology is assumed to be constant.

 Secondly, it is assumed that one factor of s must always be kept

constant.

 Thirdly the law is not applicable when the two inputs are used in
fixed proportion.
LAW OF VARIABLE PROPORTION
As the use of an input increases with other inputs fixed, the
resulting additions to output will eventually decrease.
 MP is slope of line tangent to
corresponding point on TP
curve

112

C 30

60 20
B
10

0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Labor Labor
Analysing the Production Function: Long
Run
 The long run is defined as the period of time taken to vary
all factors of production
 By doing this, the firm is able to increase its total
capacity – not just short term capacity
 The period of time varies according to the firm
and the industry
 In electricity supply, the time taken to build new capacity
could be many years; for a market stall holder, the ‘long
run’ could be as little as a few weeks or months!
Returns to Scale

 Rate at which output increases as inputs are increased

proportionately
 Increasing returns to scale
 Constant returns to scale
 Decreasing returns to scale
 The law of returns to scale refer to the long run
analysis of production
 The law of returns to scale refer 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
RETURNS TO SCALE

Increasing return
Constant
returns (
Total product Q

Decreasing returns

Units of Input
 Technological change

 Technical changes involve involve new products

 Improvements or cost reductions for existing products
 Better ways of managing the operations of a business
Shift in the production function caused
by technological progress

Q = f(L,K)

Q = f(L,K)
 Isoquant
An isoquant shows the various combination of
commodities that can be produced
K with the help of the
given level of two inputs
Q0 = f(L,K)
 An isoquant slopes downward
 The slope of the isoquant is give by MRTS
 Isoquant are convex to the origin
 Isoquant

Input Y

10 Marginal rate of
technical substitution –
9 the slope of an isoquant
8 at a particular point

7
6
5
4
3
2
1

0 1 2 3 4 5 6 7 8 9 10
Input X
Equal Cost Lines
The locus of all combinations of labor and capital which satisfy
the cost function is called the equal cost curve or isocost line

A
Slope = w/r
C1/W

O L
C0/W B
 Isocost
 The combinations of inputs K New Isocost Line
that produce a given level of associated with higher
C1/r costs (C0 < C1).
output at the same cost:
C0/r
 For given input prices,
C0 C1
isocosts farther from the L
C0/w C1/w
origin are associated with
K
higher costs. New Isocost Line for
C/r a decrease in the
 Changes in input prices wage (price of
change the slope of the labor: w0 > w1).
isocost line.

L
C/w0 C/w1
 Output maximisation subject to a given
cost.
K

Point of Cost
Minimization
Slope of Isocost
=
Slope of Isoquant

L
 Cost minimization subject to a given
level of output
K

Point of Cost
Minimization
Slope of Isocost
=
Slope of Isoquant

L
 EXPANSION PATH

Units of Y
B3

B2
PX MPX
=
PY MPY
B1

Expansion path
Y3
Y2
Y1 B C
A
Q3
Q2
Q1
X1 X2 X3
Units of X