Production Analysis- MEFA.pptx

Production Analysis
Managerial Economics and Financial Analysis

UNIT-II
Elasticity of Demand, Demand Forecasting and
Production Analysis
Contents
Elasticity of demand
• Concept of Elasticity
• Types of Elasticity
• Price, Income, Cross and
Advertising
• Factors affecting and
Significance of Elasticity
of demand
Demand Forecasting
• Need for Demand
Forecasting
• Factors governing
Demand Forecasting
• Methods of Demand
Forecasting(Survey
methods and Statistical
Methods)
Production Analysis
• Factors of Production
• Production Function
 Production Function with one
variable input, two variable inputs
using Isoquant and Iso costs
 Optimal Combination of
Resources using Isoquants and
Iso costs, Law of returns
 Economies and Diseconomies of
Scale
2

Production Analysis
 “Production is the process that transforms inputs into output.”
 This process of transformation can be
 A change in Form(RM to FG) (Wood to Furniture)
 A change in Space ( transport)
 A change in time ( storage)
 These three kinds of transformation help in
enhancing usability of goods and services

Production Analysis
“Production is the process by which the resources (input) are
transformed into a different and more useful commodity. Various
inputs are combined in different quantities to produce various
levels of output.”
Production involves producing, storing and distributing goods and
services-both tangible( steel etc.) and intangible(banking and
insurance).
In this production process, the manager is concerned with
efficiency in the use of the inputs
 Technical vs. Economic efficiency

Production Analysis
 Economic efficiency: occurs when the cost of producing a
given output is as low as possible.
 Technological efficiency: occurs when it is not possible to
increase output without increasing inputs.
 Factors affecting Production
 Technology
 Inputs
 Time period of production

Production Analysis
 Factors of Production
 Factors that are used for production are called factors of production. There
are four important factors of production. They are :
Land
Labour
Capital
Entrepreneurship/Organisation
 Factor of Production Price
 Land Rent
 Labour (skilled, semi-skilled and unskilled) Wage
 Capital Interest
 Entrepreneurship/ Organisation Profits

Production Analysis
Fixed and Variable Input
A fixed input is the one whose quantity cannot be varied
during the period under consideration.
Ex-Plant and Equipment
An Input whose quantity canbe changed during the period
under consideration is known as variable input.
Ex- Raw materials, labour, power, transportation etc.,

Production Function
 The Production function is purely a technological relationship
which express the relationship between output of a good and
the different combinations of inputs used in production.
 It indicates the maximum amount of output that can be
produced with the help of each possible combination of input.
Q = f(L, K,N, …..)
Where
Q= Amount of output L= Labour
K= Capital N= Land

Production Function
The production function rests on two main
assumptions
Technology is invariant
It is assumed that firms utilise their inputs at maximum
level of efficiency
For our current analysis, let’s reduce the inputs to
two, capital (K) and labour (L):
Q = f(L, K)

Production Analysis
Production Function with One Variable Input
 Law of variable proportions of Production Function (or)
 Shor-run analysis of Production function (or)
 Law of diminishing marginal returns (or)
This Law states that as more and more of one input is
employed, all other input quantities held constant, a point
eventually be reached where additional quantities of the
varying input will yield diminishing marginal contributions
to total product.

Relationship Between Total, Average,
and Marginal Product: Short-Run Analysis
Total product (TP): The total amount of
output resulting from a given production function
Average product(AP): Total product per unit
of given input factor.
Marginal product(MP): The change in total product
per unit change in given input factor.

Production Analysis

Production Analysis
 In the I stage, the TP rises at an increasing rate. AP and MP also
rises, MP rises at a higher rate than the AP. This stage is described
as the stage of increasing returns.
 In the II stage AP and MP begins to diminish, the TP rises at a
diminishing rate. When the AP is maximum the MP is equal to the
AP. When the MP becomes zero the TP is the maximum. This stage
is described as diminishing returns stage.
 In the III stage the TP begins to diminish, the AP is decreasing at
this stage but remains positive up to certain point. In the III stage
the MP becomes negative.

Three Stages of Production
Total Product
(TP)
Average Product
(AP)
Marginal Product
(MP)
STAGE I
Increases at an
increasing rate
Increases (but slower
than MP)
Increases and reaches
its maximum
STAGE II
Increases at a
diminishing rate and
becomes maximum
Starts diminishing Starts diminishing and
becomes equal to zero
STAGE III
Reaches its maximum,
becomes constant and
then starts declining
Continues to diminish
(but must always be
greater than zero)
Keeps on declining and
becomes negative

 STAGE 1 : INCREASING RETURNS
 As the production of one factor in the combination of factor is
increased upto a point, the MP of the factor will increase.
Reasons:
 Indivisibility of factors
 Quantity of fixed factor
 Division of labour
 Economies

 STAGE 2 : DIMINISHING RETURNS
 As the production of one factor in the combination of factor is
increased after a point the average & MP of that factor
will diminishing.
Reasons:
 Scarcity of fixed factors
 Indivisibilty of fixed factor
 Lack of perfect substitution of factor of production

 STAGE 3 : NEGATIVE RETURNS
 MP of variable factor is negative.
 Reasons:
 Excessive variable factor
 Inefficiency of fixed factor

Production Function with Two-variable Inputs
Isoquants
 An Isoquant is a curve representing various combinations of
two variable inputs that produce same amount of output.
 “Iso” means equal “Quant” means quantity.
 This is also known as Iso-Product curve, Equal-Product curve or
Production Indifference curve.

Isoquants

Isoquants
This may be taken either as a short run or a long
run analysis of production process.
Long run analysis : The firm uses only two inputs and
both of them are variable.
Short run analysis : The firm uses more than two
inputs but only two of them are variable and others
are fixed.

Isoquants
Types of Isoquants
 Depending upon the degrees of substitutability of inputs, there are four types
of Iso-quants.
Linear Isoquant
Input-Output Isoquant
Kinked Isoquant
Smooth Convex Isoquant

Types of Isoquants
1. Linear isoquant
 Perfect substitutability between factors of production

Types of Isoquants
2. Input-Output Isoquant/Right angle Isoquant/Leontief
Isoquant
Strict complementarily /zero substitutability between input
factors

Production Function with
Two-variable Inputs
Types of Isoquants
3. Kinked Isoquant
Limited substitutability
between input factors
Activity analysis (or)
Linear programming
isoquant

Types of Isoquants
4. Smooth Convex Isoquant
 Continuous substitutability over a certain range between the
input factors

Isoquants
Features of Isoquants:
 An Isoquant is downwards sloping to the right
 Higher Isoquant represents larger output
 Isoquants are convex to the origin
 No two isoquants intersect or touch each other
 Do not touch axes

Production Function
with Two-variable Inputs
Isoquant Map
 Equal Product Map
 When the whole array of
isoquants are represented on
a graph, it is called an
Isoquant Map.
 It shows how output vary as
the factor inputs are
changed

MRTS
 The slope of Isoquant has a technical name.
 The Marginal rate of technical substitution refers to the r
ate at which one input factor is substituted with other to attain
a given level of output.
 MRTS = dk
dL
 MRTS is the number of units of an input factor ( ex: K ) that
a producer is willing to sacrifice for an additional unit of
another input factor (ex: L) , so as to maintain the same level of
output. (i.e., to remain on the same isoquant.)

ISO Cost Line (or)
Budget Line
 Iso costs refers to that cost curve
that represents the combination of
inputs that will cost the producer the
same amount of money.
 In other words, each iso cost
denotes a particular level of total
cost for a given level of production.
 If the given level of production
changes, the total cost changes and
thus the iso cost curve moves
upwards. And vice versa.

Optimum Combination of Inputs
(or)
Least Cost Combination of Inputs
 Expansion Path
 Expansion path gives the least cost input combinations for every
level output.
 The point or an Expansion path occur when iso-cost line and
isoquant tangent.
 At the points of tangency between isoquants and the slope of iso-
cost lines, the slope of isoquant(MRTS) is equal to iso-cost line.
 It is the locus of different points of equilibrium when the firm's produ
ction expenditure changes, input prices remaining constant.
 Superimposing the iso-costs on isoqant curve

Optimum Combination of Inputs
(or)
Least Cost Combination of Inputs
 Expansion Path

Production Function with all variable Inputs
Laws of Returns to Scale
 According to the law, the long run output can be increased by changing all the
factors in the same proportion, or by different proportions.
 Returns to scale show the responsiveness of total product when all the inputs
are increased proportionately. Returns to scale is a factor that is studied in the
long run. Returns to scale can be constant, increasing or decreasing.
 The returns to scale may be of three types
 Increasing Returns to Scale
 Decreasing Returns to Scale
 Constant Returns to Scale

Production Function with all
variable Inputs
 Increasing Returns to Scale
 If the proportionate change in output is
more than the proportionate change in
input, then we say that there are
increasing returns to scale (IRS).
 IRS: %ΔQ > %ΔI

variable Inputs
 Decreasing Returns to Scale
 If the proportionate change
in output is less than the
proportionate change in input,
then we say that there are
decreasing returns to scale
(DRS).
 DRS: %ΔQ < %ΔI

variable Inputs
 Constant Returns to Scale
 If the proportionate change in
output is same as the
proportionate change in input,
then we say that there are
constant returns to scale
(CRS). Symbolically,
 CRS: % ΔQ = %ΔI

Production Function
with all variable Inputs
 Variable returns to scale
 The most typical situation is
for a production function to
have first increasing then
decreasing returns to scale.

 The increasing returns to scale are attributable to
specialisation. As output increases, specialised labour can be
used, and efficient large-scale machinery can be employed in
the production process. However, beyond some scale of
operations not only are further gains from specialisation
limited, but also coordination problems may begin to increase
costs substantially. When coordination costs more than offset
additional benefits of specialisation, decreasing returns to
scale begin.

Cobb-Douglas Production Function
 In 1928 Charles Cobb and Paul Douglas published a study in
which they modelled the growth of the American economy
during the period 1899 - 1922.
 The Cobb-Douglas functional form of production functions is
widely used to represent the relationship of an output to
inputs.
 Originally Cobb-Douglas production function applied to the
process of an individual firm but to the whole of the
manufacturing production.

 Cobb-Douglas production function takes the following mathematical form
Q=A Lα K β
 Where
 Q= Output, L= Labour, K=Capital, α , β are positive parameters, α>0,
β >0
 The Equation tells that output depends directly on L and K and that part of
output which cannot be explained by L and K is explained by A which is
the 'residual' often called technical change.
 The marginal products of labour and capital are the functions of the
parameters A, α and β and the ratios of labour and capital inputs.

 The function estimated for the USA by Cobb and Douglas is
Q= 1.01 L0.75 C0.25
 R2= 0.9409
 The production function shows that one percent change in labor input, capital
remaining the same, is associated with a 0.75 percent change in output. Similarly,
one percent change in capital, labor remaining the same, is associated with a 0.25
percent change in output. The coefficient of determination(R2) means that 94
percent of the variations on the dependent variable(Q) were accounted for by the
variations in the independent variables ( L and C). It indicates constant returns
to scale which means that there are no economies or diseconomies of large scale
of production. On an average, large or small scale plants are considered equally
profitable in the US manufacturing Industry, on the assumption that average and
marginal production costs were constant.

 MPL =dQ/dL = α A Lα-1 Kβ
 MPK= dQ/dK = β A Lα Kβ-1
α+β>1 = Increasing returns to scale
α+β=1 = Constant returns to scale
α+β<1 = Decreasing returns to scale
Cobb-Douglas production function is a non-linear in its general
form, it can be transferred into linear function by taking it in
its logarithmic form. This function is also known as log linear
function.
LogQ= logA+alogL+plogK

Economies and Diseconomies of Scale
 Economies of Scale
 Economies of scale are the cost advantages that an enterprise
obtains due to expansion.
 It leads to reduction in unit costs as the scale of operations
increases.
 Diseconomies of Scale
 Diseconomies of scale are the disadvantages of being too large. A
firm that increases its scale of operation to a point where
it encounters rising long run average costs is said to be
experiencing internal diseconomies of scale.

Economies of Scale
Cost per unit decreases when quantity produced
increases
Economies of scale is a cost advantage that an
enterprise obtain due to expansion. It leads to the result
in lower unit cost.
Economies of scale occur when increased output leads
to lower unit costs or firm's marginal costs of production
decrease
Company A producing 100 units of ball, where cost per
unit is Rs. 50. At the same time, Company B producing
1000 units of ball, where cost per unit is Rs. 30 .

Economies of Scale
 The economies of Scale are classified as:
 Internal or Real Economies
 External or Pecuniary Economies
 Internal Economies or Real Economies
 Internal economies are those which arise from the expansion
of the plant size of the firm. This means internal economies
are exclusively available to the expanding firm.
 Those Specifically related to the business or firm itself

Types of Internal economies of scale
 Labour Economies
 Technical Economies
 Managerial Economies
 Marketing or Commercial Economies
 Financial Economies
 Transport & Storage Economies
 Risk bearing Economies

External Economies of Scale
 They are those benefits or advantages available to all the
firms in the industry from outside, irrespective of their size and
scale of operation, due to expansion of the industry size.
 Economies of Localisation / Concentration`
 Economies of Research and development
 Economies of Welfare
 Economies of Vertical disintegration
 Economies of By- products

Diseconomies of Scale
 Diseconomies of scale are the forces that cause larger firms
and governments to produce goods and services at increased
per-unit costs. The concept is the opposite of economies of
scale referring to a situation in which economies of scale no
longer function for a firm. Rather than experiencing
continued decreasing costs per increase in output, firms see
an increase in marginal cost when output is increased.
 The diseconomies of scale are two:
 Internal diseconomies of scale
 External diseconomies of scale

 Internal diseconomies of scale
Managerial inefficiency
Labour inefficiency
 External diseconomies of scale
Breakdown of relationships with suppliers and buyers
Competition for labour
Increasing employment costs
Traffic congestion

 Division of labor has reached its most efficient point, further
increase in the number of workers will lead to duplication of
workers
 The problem of coordination of different processes may
become difficult.
 There may be divergence of views concerning policy
problems among specialists in management and
reconciliation may be difficult to arrive.
 Too much of red-tapism
 Supervision may become difficult

 Management problems adverse effects of managerial efficiency
 With the growth in the size of the organization, the control by those
at the top becomes weaker. Adding one more hierarchical level
removes the superior further away from the subordinates.
 As the firm expands the incidence of wrong judgments increases
and errors in judgment become costly.
 Loss from Technological change.
 Decision making process becomes slow.
 Planning, organizing, controlling etc.,

Economies and Diseconomies of Scale

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