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# Production Analysis

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### Production Analysis

1. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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 ∆Fwhere 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. 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. 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. 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.