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# Production analysis by Neeraj Bhandari ( Surkhet.Nepal )

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### Production analysis by Neeraj Bhandari ( Surkhet.Nepal )

1. 1. Unit -4 Production Analysis
2. 2.  Key Concepts in Production Analysis • PPC, Input-Output, Fixed &Variable Inputs , Short run & Long run.  Production Function and its various determinants.  Law of Production • Law of Variable Proportions • Law of return to scale
3. 3. Production Possibility Curve (PPC)  Production Possibility Curve is the curve which shows the combinations of two goods and services that can be produced with fuller utilization of a given amount of resources in the most efficient way and with a given production technology. It is also known as Transformation curve. PPC is concave to origin. This is because of the increasing opportunity cost i.e. in accordance with the law of increasing opportunity cost.  In order to understand this, let us take an example. Production Possibilities Consumer Goods (units) Capital Goods (units) A 50 0 B 48 1 C 44 2 D 35 3 E 0 4
4. 4. • In the above figure, as we move downwards along the PPC from left to right (i.e. from A to E ), we observe that in order to produce more units of capital goods, the economy must sacrifice some amount of consumer goods. In other words, it reflects the opportunity cost of producing one good in terms of another good. For example, a movement from point B to point C implies that the economy is diverting resources from the production of consumer goods to the production of capital goods. In order to produce one additional unit of capital good, the economy is sacrificing four units (i.e. 48 – 44 units) of consumer goods. Thus, the opportunity cost of producing one additional unit of capital goods is 4 units of consumer goods.
5. 5.  Input and Output: • An input is a good or service that goes into the process of production. Land, Labour, Capital, Management, Entrepreneur and Technology are classified as inputs. • An output is any good or service that comes out of the production process.  Short Run and Long Run: • Short run refers to a period of time in which supply of certain inputs i.e., plant, building and machinery etc. is fixed or inelastic. • Long run refers to a time period in which the supply of all the inputs is elastic or variable.  Fixed Inputs & Variable Inputs: • Fixed inputs remains fixed (constant) up to certain level of output. • Variable inputs change with the change in output.
6. 6. Production Function  Production function is defined as “the functional relationship between physical inputs ( i.e., factors of production ) and physical outputs, i.e., the quantity of goods produced”.  Production function may be expressed as under: Q = f ( K,L) Where ; Q = Output of commodity per unit of time. K = Capital. L = Labour. f = Functional Relationship.
7. 7.  Production function depends on : • Quantities of recourses used. • State of technical knowledge. • Possible process. • Size of firms. • Relative prices of factors of production.
8. 8.  The following points may be emphasized: • Production function represents a purely technical relationship. • Output is the result of joint use of factors of production. • Combination of factors depend on the state of technical knowledge.  Every management has to make choice of the production function which gives Minimum cost and maximum average profit.
9. 9. Laws of Production  Laws of production are of two types: • The law of variable proportions. • Laws of returns to scale.
10. 10. Short Run Production Function: The Law of Variable Proportions Statement of the law: “The law of variable proportions states that when more and more units of the variable factor are added to a given quantity of fixed factors, the total product may initially increase at an increasing rate reach the maximum and then decline”.
11. 11. Tabular Presentation of Law of Variable Proportions Units of Labour TP MP AP I Stage II Stage III Stage 1 80 80 80 2 170 90 85 3 270 100 90 4 368 98 92 5 430 62 86 6 480 50 80 7 505 25 72 8 505 0 63 9 495 -10 55 10 470 -25 47
12. 12. Diagrammatical Presentation of Law of Variable Proportions Assumptions of the law: State of Technology remains the same. Input prices remain unchanged, Variable factors are homogeneous. AP MP AP MP
13. 13.  A Rational producer will never choose to produce in stage III where Marginal Productivity of variable factor is negative. It will stop at the end of the second stage where Marginal Productivity of the variable factor is Zero. At this point the producer is maximizing the total output and will thus be making the maximum use of the available variable factors.  A producer will also not choose to produce in Stage I where he will not be making full use of the available resources as the average product of the variable factor continues to increase in this stage.  A producer will like to produce in the second stage. At this stage Marginal and Average Product of the variable factor falls but the Total Product of the variable factor is maximum at the end of this stage. Thus stage II represents the stage of rational producer decision. Law of Diminishing Returns and Business Decisions
14. 14. Long Run Production Function: The Returns to scale  The long run production function is termed as returns to scale. In the long run, the output can be increased by increasing all the factors in the same proportions.  The laws of returns to scale is explained by the help of Isoquant curves. An Isoquant curve is the locus of points representing various combination of two inputs, Capital & Labour, yielding the same output.
15. 15. ISOQUANTS Isoquant is one way of presenting the production function where two factors of production are shown. It represents all possible input combinations of the two factors, which are capable of producing the same level of output. IQ O Y X a b c d LABOUR C A P I T A L ΔK ΔL ΔK ΔL ΔK ΔL
16. 16. Combinatio ns Labour (L) Capital (K) MRTS L K Out Put A B C D E 1 2 3 4 5 12 8 5 3 2 - 4:1 3:1 2:1 1:1 100 100 100 100 100 Tabular Presentation of MRTSLK
17. 17. Iso-Cost Lines • It shows all the combinations of the two factors ( say labour and Capital) that the firm can buy with a given set of prices of two factors. • It plays an important role to determine combinations of factors, the firms will choose for production ultimately to minimize cost. O X Y PRICE OF LABOUR P R I C E OF C A P I T A L A B C D EE F
18. 18. Producers Equilibrium or the Least Cost Combination of Factors • A producer desires to minimise his cost of production for producing a given level of output with the least cost combination of factors. E P R S T IQ IQ1 IQ2 LABOUR C A P I T A L A BO X Y How producers ultimately arrives the point of equilibrium ? •The equilibrium is achieved at the point Where MRTS LK = PL/PK ie • The slope of isoquant =Slope of isocost •Or , MRTS LY = MPL = PX MPK PY Or, MPL = MPK PX PY
19. 19. There are three technical possibilities; a) Total output may increase more than proportionately: Increasing returns to scale, b) Total output may increase at a constant rate: Constant Returns to Scale, c) Total output may increase less than proportionately: Diminishing returns to scale. Causes: Managerial Diseconomies. Scarce and Exhaustible resources. Causes: Indivisibilities of Factors, High degree of specialization Causes: Factors of production fully utilised. Technology remains unchanged