1.
PRODUCTION ANALYSIS
Production Function
•The technological physical relationship between inputs
and outputs per unit of time, is referred to as
production function.
•The relationship between the inputs to the production
process and the resulting output is described by a
production function.
•“The production function is the name given to the
relationship between rates of input of productive services
and the rate of output of the product. It is the economist’s
summary of technical knowledge.”-Stigler.
Explanation of the meaning of Production Function:
The theory of production begins with some prior
knowledge of the technical and/or engineering information.
For instance, if a firm has a given quantity of labour, land
and machinery, the level of production will be determined
by the technical and engineering conditions and cannot be
predicted by the economist. The level of production
depends on technical conditions. If there is improvement in
the technique of production, increased output can be
obtained even with the same (fixed) quantity of factors.
However, at a given point of time, there is only one
maximum level of output that can be obtained with a given
combination of factors of production. This technical law
which expresses the relationship between factor inputs and
output is termed as production function.
2.
Fixed Inputs
•A fixed input is defined as one whose quantity cannot be
changed instantaneously in response to changes in market
conditions requiring an immediate change in output.
•E.g., Buildings, major capital equipments and managerial
personnel.
Variable Inputs
•A variable input is one whose quantity can be changed
readily when market condition suggests that an immediate
change in output is beneficial to the producer.
•E.g. raw materials and labour services.
Short Run
•The short run is that period of time in which quantity of
one or more inputs remains fixed irrespective of the volume
of output.
•Therefore, if output is to be increased or decreased in the
short run, change exclusively in the quantity of variable
inputs is to be made.
Long Run
•Long run refers to that period of time in which all inputs
are variable.
•Thus, the producer does not feel constrained in any way
while changing the output.
•In the long run it is possible for the producer to make
output changes in the most advantageous way.
Production process or method of production is a
combination of factor inputs for producing one unit of
output
3.
What are Isoquants?
ISO – means equal, QUANT – means quantity.
•Isoquant literally means Equal Quantity.
•Isoquant curve can also be called
Isoproduct curve. This curve represents equal quantity
of output produced using various combinations of inputs.
An Isoquant is the locus of all the combinations of two
factors of production that yield the same level of output.
.
Assumptions of Isoquants
•1. It is generally assumed that there are only two factors or
inputs of production.
•2. The factors of production are divisible into small units
and can be used in any proportion.
•3. Technical conditions of production are given and cannot
be changed.
•4. Given the technical conditions of production,
different factors are used in the most efficient
manner.Properties of Isoquants
•1. Isoquants are negatively sloped
i.e.,slope downward from left to right.
•2. A higher Isoquant represents a larger output.
•3. No two Isoquants intersect each other.
•4. Isoquants are convex to the origin.
- because the marginal rate of technical
substitution tends to fall.
Types of Isoquants
•Types of Isoquants
(1) Linear Isoquant
•There is perfect substitutability of inputs.
4.
•Given output – say 100 units – can be produced by using
only capital or only labour or by a number of combinations
of labour and capital. – both are perfectly substitutable.
•Given a power plant, equipped to use either oil or gas,
various units of electric power can be produced by burning
gas only, oil only or in varying combinations of each. Both
gas and oil are perfect substitutes.
Linear Isoquants
Oil
(2) Right angle Isoquant
•Here there is complete non-substitutability between the
inputs (strictly complimentary).
•For example, exactly two wheels and one frame are
required to produce a bicycle and wheels cannot be
substituted for frames.
•Similarly, two wheels and one chassis are required for a
scooter.
•This is also known as Leontief Isoquant.
Right angle Isoquant
Chassis
(3) Convex Isoquant
•This form assumes imperfect substitutability of inputs.
•E.g. A shirt can be made with more wastage of cloth when
less care (less labour) is used.(C1)
•If more is spent on labour, the shirt can be made with less
cloth, wastage being less.(C2)
•If still more care is taken by spending more on labour,
minimum wastage is done, by using still
lesser amount of cloth.(C3)
Convex Isoquant
Cloth
5.
Economic Region of an Isoquant
When relatively small amount of a factor is combined with
relatively large amount of another factor in an iso-quant, in
such a manner that the marginal productivity of this
abundant factor tends to be negative, resulting in decline in
total output. In such cases, the end portions of the curves
are regarded as uneconomical. Thus when extended on
either side, the iso-quants are oval shaped.
Economic region of the iso-quant is determined by drawing
tangents to the curves parallel to the two axes, and the
points of tangency indicate zero marginal productivity of
the abundant factor.
Economic Region
Difference between Equal Product Curve (Isoquant) and
Indifference Curve
Indifference Curves
•
•Indifference curves indicate level of satisfaction.
•Indiffernce curves relate to combinations between two
commodities.
•Indifference curves cannot be labelled easily as there is no
numerical measurement of the satisfaction involved.
•On indifference map, between higher and lower
indifference curve, the extent of difference in the
satisfaction is not quantifiable.
Equal Product curves
•
• Equal product curves indicate quantity of output.
6.
•Equal product curves relate to combinations between two
factors of production.
•Equal product curves can be labelled easily as physical
units of output represented by it are measurable.
•On equal product map, we can measure the exact
difference between output represented by one iso-quant and
another iso-quant.
Cobb-Douglas Production Function
Cobb-Douglas production function relates output in
American Manufacturing industries to labour and capital
inputs, taking the form
P = a(LbC1-b) …a and b are +ve constants.
P = total output (production)
L = index of labour employed in manufacturing
C = index of fixed capital in manufacturing
b and 1-b are elasticities of production representing
percentage response of output to percentage changes in
labour and capital.
The above stated production function is a linear and
homogeneous function of degree, one which establishes
constant returns to scale.
PRODUCTION FUNCTIONS
- Main Concepts
The Main concepts of Production Functions are:
1. The marginal productivity of factors of
production.
2. The marginal rate of technical
substitution.
3. Elasticity of substitution
4. Factor intensity
7.
5. The returns to scale.
Marginal Product of Factors
The marginal product of a factor of production is defined as
a change in output due to a very small change in the
quantity of this factor while quantities of all other factors of
production remain constant.
Marginal rate of technical substitution
•The marginal rate of technical substitution of labour for
capital is that quantity of capital which has to be reduced
on an increase in the use of labour by one unit to keep the
level of production constant.
Table showing Marginal Rate of Technical Substitution
Elasticity of Technical Substitution
•The elasticity of technical substitution is defined as the
percentage change in the ratio of the two factors of
production (say, capital – labour ratio), divided by the
percentage change in the marginal rate of technical
substitution.
percentage change in K/L
•Es = -------------------------------------
percentage change in MRTSLK
Factor Intensity
In any process, if only two factors (e.g.,capital and labour)
are used, the facor intensity refers to capital-labour ratio.
If K1/L1 > K2/L2
it shows that the former process is more capital intensive
than the latter.
Returns to Scale
8.
•Commonly used General Production Function:
X = f (L, K, v, u )
Law of Diminishing Marginal Returns
Marshall stated this law as follows:
“An increase in capital and labour applied in the cultivation
of land causes in general a less than proportionate increase
in the amount of produce raised, unless it happens to
coincide with an improvement in the arts of agriculture.”
In the initial stages of cultivation of a given piece of
land, perhaps due to under-cultivation of land, when
additional units of capital and labour are invested,
additional output may be more than proportionate. But after
a certain extent when the land is cultivated with some more
investment, the additional output will be less than
proportionate under all normal circumstances, unless some
improvements take place in the methods of techniques of
cultivation.
The law is applicable to all fields of production such
as industry, mining, house construction, besides agriculture.
Assumptions of the Law of Diminishing Marginal Returns
•The law of diminishing marginal returns holds good
subject the following two conditions:-
•1. Same technology is used throughout the process of
production. Whatever change takes place in the proportion
of factor inputs is within the scope of available methods
and techniques.
•2. Units of different factor inputs are perfectly
homogeneous; every unit is of equal efficiency and
therefore, are interchangeable with any other factor input in
the production function.
9.
Law of Variable Proportions
•Prof. Benham states the law as follows:
•“As the proportion of one factor in a combination of
factors is increased after a point, the average and
marginal production of that factor will diminish”.
•G. J. Stigler:
•“As equal increments of one input are added, the inputs
of other productive services being held constant, beyond
a certain point the resulting increments of product will
decrease, i.e. the marginal product will diminish.”
•The law is summarised thus:
•In the short run, as the amount of variable factors
oincreases, other things remaining equal, output (or the
returns to the factors varied) will increase more than
proportionately to the amount of variable inputs in the
beginning, then it may increase in the same proportion
and ultimately it will increase less proportionately”.
Law of Variable Proportions(contd.)
•The conditions underlying the law are :
Only one factor is varied; all other factors remain
constant.
The scale of output is unchanged and production capacity
remains constant.
Technique of production is unchanged.
All units of factor input varied, are homogeneous – all
units have identical efficiencies and characteristics.
All factors of production cannot be substituted for one
another.
Measurements of the Product
10.
•Total Product: Total number of units produced per unit of
time by all factor inputs in referred to as total product. In
the short run, since Total Product (output)(TP) increases
with an increase in the Quantity of Variable Factor (QVF),
TP = f(QVF).
•Average Product: Average Product refers to the total
product per unit of the given variable factor. AP
= TP/QVF
•Marginal Product: Owing to the addition of a unit to a
variable factor, all other factors being held constant, the
additional realised in the total product is technically called
marginal product.
»MPn = TPn – TPn-1
»
1.Stage I – The law of diminishing returns becomes evident
in the marginal product line. Initially the marginal product
of the variable input (labour) rises. The total product rises
at an increasing rate (=marginal product). Average product
also rises. This is the stage of increasing returns.
2.Stage II – Reaching a certain point, the marginal product
begins to diminish. Thus, the rate of increase in the total
output slows down. This is the stage of diminishing returns.
When the average product is maximum, the average
product is equal to the marginal product.
3.Stage III – As the marginal product tends to diminish, it
ultimately becomes zero and negative thereafter.
•When the marginal product becomes zero, the total product
is the maximum. Thus when marginal product becomes
negative, the total product begins to decline in the same
proportion. Even though AP is decreasing, it does not
become negative immediately.
11.
THE LAWS OF RETURNS TO SCALE
Statement of the Law:
“As a firm in the long run increases the quantities of all
factors employed, other things being equal, the output may
rise initially at a more rapid rate than the rate of increase in
inputs, then output may increase in the same proportion of
input, and ultimately, output increases less
proportionately.”
•Assumptions:
•1. Technique of production is unchanged.
•2.All units of factors are homogeneous.
•3.Returns are measured in physical terms.
There are three phases of returns in the long run:
•(1) the law of increasing returns
•(2) The law of constant returns
•(3) The law of diminishing returns.
The law of Increasing Returns
•This law describes increasing returns to scale. There are
increasing returns to scale when a given percentage
increase in input will lead to a greater relative percentage
increase in output.
∆Q r ∆Fwhere proportionate
Q F change in output >
proportionate change in inputs
(factors)
Production Function Coefficient (PFC)
•In the long run, PFC, is measured by the ratio of
proportionate change in output to proportionate change in
input.
∆Q/Q = ∆Q x F
12.
∆F/F Q ∆F
•PFC > 1 means increasing returns to scale.
Law of Constant Returns
•The process of increasing returns canot go on for ever.
•It is followed by constant returns to scale.
•While expanding its scale of production, the firm gradually
exhausts the economies responsible for increasing returns.
Thereafter, constant returns occur.
•When PFC coefficient is = 1, it will be constant returns to
scale.
The Law of Decreasing Returns
As expansion is continued, growing diseconomies of
factors are encountered. When powerful diseconomies are
met by feeble economies of certain factors, decreasing
returns to sclae results. This happens when PFC
(production function coefficient) < 1.
Causes for decreasing returns:
•1. Though all physical factors are increased
proportionately, organization and management as a factor
cannot be incresed in equal proportion.
•2. Business risk increases more than proportionately when
scale of production is enhanced. Entrepreneurial efficiency
also has its limitations.
•3. Growing diseconomies of large-scale production set in
when scale of production increases beyond a limit.
•4. Problem of supervision and coordination becomes
complex and intractable in a large scale operation and
becomes unwieldy to manage.
13.
•5. Imperfect substitutability of factors of production causes
diseconomies resulting in a declining marginal output.
Estimation of Production Functions
(1)Linear Production Function:
•A linear production function would tke the form:
•Total Product : Y = a + bX
•Equation for average product would be Y = a + b
X X
Equation for the marginal product would be ∆Y b
∆X
(2) Power Function
•A power function expresses output Y, as a function of
input X in the form
Y = aXb
Some important properties of such power functions are
•The exponents are the elasticities of production. Here,
exponent
‘b’ represents elasticity of production.
•The equation is linear in the logrithms, that is, it can be
written
as log Y = log a + b log X
When expressed in logarthmic form as above, the
coefficient ‘b’ represents elasticity of production.
(iii) When one input is increased while all others are held
constant, marginal product will decline.
(3)Quadratic Production Function
The quadratic production function may take the form:
Y = a + bX – cX2
Where the dependent variable ‘Y’ represents total output
and the independent variable ‘X’ denotes input. The a, b
14.
and c are parameters; their values are determined by
statistical analysis of data.
Special properties of Quadratic production function are as
under:-
•The minus sign in the last term denotes diminishing
marginal returns.
•The equation allows for decreasing marginal product but
not for both incresing and decreasing marginal product.
•The elasticity of production is not constant at all points
along the curve as in a power function, but declines with
input magnitude.
•The equation never allows for an increasing marginal
product.
•When x = , Y = a. This shows that there is some output
even when no variable input is applied.
•The quadratic equatioin has only one bend as compared
with a linear equation which has no bends.
(4) Cubic Production Function
The cubic production function takes the form:
Y = a + bX + cX2 - dX3
Some important properties of cubic function are :
•It allows for both increasing and decreasing marginal
productivity.
•The elasticity of production varies at each point along the
curve.
•Marginal productivity decreases at an increasing rate in the
later stages.