Production Analysis

Meaning of Production
Factors of Production
Production Function and it’s attributes
Time element & production function (sort-run and Long-run
production function.
Cobb- Douglas Production Function
Law of Diminishing marginal return
Law of variable proportion
Law of return to scale (explain by isoquants)
Output Elasticity
Production function through Isoquants curve and Iso-cost
line
Producer’s Equilibrium
Economics of Scale and Scope.
 Meaning of Production

• Production implies provision of goods and

services (Commodities)
• Transformation of resources into commodities
over time and/or space.
• Production is flow concept measured as rate
of output per unit of time.
 The concept of Production Function
•
Production Function and it’s attributes

• Production function- refers to the physical

relationship between the use of the inputs
(Factor of productions) and resulting output of
a product
 Attributes of production function
 Flow concept
 Physical ( not monetary)
 State of technology
 Inputs- some inputs are substitute to one
another and some inputs may be specific
 Factors’ combination for the maximum
output
 short run and long run production function
 Time element & production function
• sort-run and Long-run production function
 Isoquant Map:
Production with Two Variable Inputs (L,K)
Capital
per year 5 E
Isoquants showing all possible combinations
of inputs that yield the same output
4

3
A B C

2
Q3 = 90
D Q2 = 75
1
Q1 = 55
1 2 3 4 5 Labor per year
 ISOQUANTS - Properties
• Isoquants farther from the origin represent
higher input and output levels.
• Given a continuous production function,
every possible input bundle is on an
isoquant and there is an infinite number of
possible input combinations.
• Isoquants slope downward to the left and
are convex to the origin.
 Marginal Rate of
Technical Substitution
Capital
5
per year
Isoquants are downward
2 sloping and convex
4 like indifference
curves, indicating declining MRTS.

1
3
1
1
2
2/3 1 Q3 =90

1
1/3 Q2 =75
1
Q1 =55

1 2 3 4 5
Labor per month
 MARGINAL RATE OF TECHNICAL
SUBSTITUTION
• Marginal rate of technical substitution (MRTS):
Shows the rate at which one input is substituted
for another (with output remaining constant)
• Q = f(X1, X2)
– MRTS = –X2/X1 with Q held constant and X2 on the
vertical axis
– MRTS = MP1/MP2
– MRTS = Absolute value of the slope of an isoquant
 MARGINAL RATE OF TECHNICAL
SUBSTITUTION

• MRTS and isoquants (with X2 on the

vertical axis)
– If the MRTS is large, it takes a lot of X2 to
substitute for one unit of X1, and isoquants will
be steep.
– If the MRTS is small, it takes little X2 to
substitute for one unit of X1, and isoquants will
be flat.
 MARGINAL RATE OF TECHNICAL
SUBSTITUTION

• MRTS and isoquants (with X2 on the vertical

axis) (Continued)
– If X1 and X2 are perfect substitutes, MRTS is
constant, and isoquants will be straight lines.
– If X1 and X2 are perfect complements, no
substitution is possible, MRTS is undefined, and
isoquants will be right angles.
 MARGINAL RATE OF TECHNICAL
SUBSTITUTION

• Ridge Lines
– Ridge lines: The lines that profit-maximizing firms
operate within, because outside of them, marginal
products of inputs are negative
– Economic region of production is located within
the ridge lines.
 Importance of time period
• Short-run:
– Period of time in which quantities of one or
more production factors cannot be
changed.
– These inputs are called fixed inputs.
• Long-run:
– All inputs are variable in the long run; so
there are no fixed inputs.
Economists seem to have a ‘fuzzy’
distinction between short & long run
 Production with One Variable Input (Labor): Relation between
AP & MP

AP = slope of line from origin to a point on TP, lines b, & c.

MP = slope of a tangent to any point on the TP line, lines a & c.
Output Output
per per
Month D Month
112

C 30
E
60 20
B

A 10
Labor Labor
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10per Month
per Month
Increasing, Diminishing and
Negative Marginal Returns
Increasing Diminishing Negative
Q Marginal Marginal Marginal
Returns Returns Returns

Q=F(K,L)

AP
L
MP
Law of Diminishing Marginal Returns

• When the labor input is small, MP

increases due to specialization (better
utilization of fixed inputs).
• When the labor input is large, MP
decreases due to inefficiencies (fixed
factors become limited in supply).
 Effect of
Technological Improvement
Output
per Labor productivity
time C can increase if there
period are improvements in
technology, even though
100 any given production
B O3 process exhibits
diminishing returns to
labor.

A
50 O2

O1

Labor per
time period
0 1 2 3 4 5 6 7 8 9 10
 Increasing Returns to Scale

Capital Increasing Returns:

(machine The isoquants move closer together
hours)
A
Reasons:
• Larger output
associated
with lower cost
4 (autos)
• One firm is more
30 efficient
than many (utilities)
20
2
10
Labor (hours)
0 5 10
Sources of increasing returns to scale

– Indivisibilities: Some technologies can only be

implemented at a large scale of production.
– Subdivision of tasks: Larger scale allows
increased division of tasks and increases
specialization.
– Probabilistic efficiencies: Law of large numbers
may reduce risk as scale increases.
 Constant Returns to Scale

Capital
(machine
hours) A
6
30
Constant Returns:
4 Isoquants are

20 equally spaced
because:
• Size does not affect
2
productivity
10 • May have a large
number of producers
0 5 10 15
Labor (hours)
 Decreasing Returns to Scale
Capital
(machine
hours) A
Decreasing Returns to
Scale: Isoquants get
further apart due to:
• Decreasing efficiency
with large size
• Reduction of
4 30 entrepreneurial abilities
2 Opposite is the case
20
10 of increasing returns
to scale
0 5 10
Labor (hours)
 Sources of decreasing
returns to scale
– Coordination inefficiencies: Larger organizations are
more difficult to manage.
– Incentive problems: Designing efficient
compensation systems in large organizations is
difficult.
- How to represent Returns to Scale
algebraically?
 Isocost
• The combinations of inputs that
K New Isocost Line
produce a given level of output at the associated with
same cost: C1/r higher costs (C0 <
wL + rK = C C1).
• Rearranging, C0/r

K= (1/r)C - (w/r)L
C0 C1
• For given input prices, isocosts L
C0/w C1/w
farther from the origin are associated
with higher costs. K
New Isocost Line
• Changes in input prices change the C/r for a decrease in
slope of the isocost line. the wage (price of
labor: w0 > w1).

L
C/w0 C/w1
 Cost Minimization in Algebra

• Marginal product per dollar spent should be

equal for all inputs:

• But, this is just

w
MRTS KL 
r
 Cost Minimization in Figure

Point of Cost
Slope of Isocost Minimization
=
Slope of
Isoquant

L
This is equivalent to cost minimization
subject to a given output level, which
is again equivalent to profit maximization
with given input & output prices.
 Optimal Input Substitution
• A firm initially produces Q0
by employing the
combination of inputs K
represented by point A at a
cost of C0.
• Suppose w0 falls to w1.
– The isocost curve rotates
counterclockwise; which
represents the same cost level A
prior to the wage change. K0
– To produce the same level of
output, Q0, the firm will
produce on a lower isocost line B
(C1) at a point B. K1
– The slope of the new isocost
line represents the lower wage
relative to the rental rate of Q0
capital.

L1 C0/w0 C1/w1 C0/w1 L

0 L0
 CONCLUSION
• The production function shows the relationship between
output and inputs.
• The marginal product of labor is the increase in output from a
one-unit increase in labor, holding other inputs constant. The
marginal products of other inputs are defined similarly.
• Marginal product usually diminishes as the input increases.
Thus, as output rises, the production function becomes flatter,
and the total cost curve becomes steeper.