Production Analysis

Mihir K Mahapatra
PGDM:2011-13 July 2011

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Why to Study about Production Analysis

Firm Aims at Maximization of Profit

Profit Depends on Output Produced, ceteris paribus

How much to Produce?

What Capacity must be Installed?

What Combinations of Inputs to be employed to Maximize

Profit?

How does a firm decides a Target level of Output to

Ensure Profit Maximization?

How does Theory of Production helps Manager to Take

the Right Decision?

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Organization of the Lecture

Rational of Production? Why do firms produce?

Production, Production function Defined
Short Run vis--vis Long Run
Production in the Short Run
Average Product, Marginal Product, Total Product
 Increasing Returns, Diminishing Returns etc.


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Production in the Long Run

Isoquant
Returns to Scale
Isocost Line
Least cost Combination
3

Production Decisions of a Firm

If a firm is a COST MINIMIZER, we can also

study
How total costs of production vary with output
 How does the firm CHOOSE the QUANTITY to
MAXIMIZE its PROFIT


We can represent the firms production

technology in the form of a production function

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Production Function

Production: Transformation of Inputs into

Outputs
Production Function: Functional / Technical/
unique relationship between
INPUTS and OUTPUTS.
Production function reflects Maximum Quantity
of a commodity that can be produced per unit of
time with each set of alternative inputs,
assuming use of available best production
technique.

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The Technology of Production

(Production Function)

Production Function:


Indicates the HIGHEST OUTPUT (Q) that a firm can PRODUCE for every
SPECIFIED COMBINATION of inputs

Describes what is TECHNICALLY FEASIBLE when the firm OPERATES

EFFICIENTLY (firm uses each combination of inputs as effectively as
possible)- Pindyck et al. 2006
Assuming a firm produce one type of output (Q) with only Labour (L) and
Capital (K)

 Q=



F(K, L)

The production function is TRUE for a GIVEN TECHNOLOGY

If technology undergoes change, more output can be produced for a given
level of inputs

Note: Production depends on many factors including technology, policy issues and so on but we
have assumed that it depends on only two factors.
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What are the Factors of Production?

Input: Resources used in the Production of goods

and services
(Labour, Capital, entrepreneur, technology, Land/or Natural Resources)

Inputs (Factors): Fixed and Variable

Fixed Factors: Inputs which can not be changed

during the period under consideration

Variable Factors: Which can be varied easily and on

every short notice.
Exp: Most Raw Material and unskilled labour. Labour is not
necessarily variable. It depends on the Labour Laws. Whether
an entrepreneur can remove a labour easily or not?

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Production in the Short Run (One Variable

Input)

One input can be varied in the Short Run

Assume Capital is Fixed and Labour is variable
Output can only be INCREASED by INCREASING
LABOUR
 How output changes as the amount of labor is
changed


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Production: One Variable Input

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Production: One Variable Input

Observations from preceding Table
1. When LABOUR is ZERO, OUTPUT is ZERO as
well
2.

With additional workers, output (q) increases up to

8 units of labor

3.

Beyond this point, output declines



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Increasing labor can make better use of existing

capital initially
After a point, more labor is not useful and can be
counterproductive
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Production: One Variable Input

Average product of Labor - Output per unit of a particular

product (Labour)
Measures the productivity of a firms labor in terms of how
much, on average, each worker can produce
AP

Output
Labor Input

q
L

Marginal Product of Labor additional output produced when

labor increases by one unit
Change in output divided by the change in labor
MPl= q/L

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Production: One Variable Input

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Production: One Variable Input

Output
per
Month

112

C
60

Total Product

At point D, output is
maximized.

A
Labor per Month
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Production: One Variable Input



How output varies with changes in labor

 Output

is maximized at 112 units (with use of 7 units

of Labour)

Average and Marginal Products

 Marginal

Product is positive as long as total output is

increasing
 Marginal Product crosses Average Product at its
maximum

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Production: One Variable Input

Output
per
Worker

Left of E: MP > AP & AP is increasing

Right of E: MP < AP & AP is decreasing
At E: MP = AP & AP is at its maximum
At 8 units, MP is zero and output is at max

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Marginal Product

20

Average Product

10

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0 1

2 3

5 6

7 8

10 Labor per Month

15

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Stages of Production in the Short Run

Increasing Returns: with the given fixed factor, increase in use of variable factors
leads to increase in Marginal Product of variable factor initially.

Ex: Use of dosages of fertilizer on a fixed plot of land

Second unit of fertilizer will contribute more to total product than the first unit of fertilizer.

Implication: Increase in Marginal Product and rise in Total Product at an increasing

Rate

Ex. When the use of labor input is small and capital is fixed, output increases
considerably since workers can begin to SPECIALISE and MARGINAL PRODUCT
of LABOUR increases
(Exp: Adam Smiths Pin Making Industry)
Ex. Initially the fixed factor (machine) is not utilized properly. With increase
in recruitment, the fixed factor can be utilised better implying improvement
in productivity

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Second Stage: Diminishing Marginal Returns

Law of Diminishing Marginal Returns:

As

the use of an input increases with other inputs fixed, the resulting
additions to output will eventually decrease after a point of time
A phase when Marginal Product associated with increment of the
variable inputs begin to fall, leading to increase in total product at a
decreasing rate.
Ex: When the use of labor input is large, some workers become less
efficient and Marginal Product of labor decreases

With Increase in Employment, Marginal Product of labour can be Zero. How?

(With too many workers, some may have to stand around or cannot be utilised
properly. May be overtime workers are less productive)

Ex: Disguised Unemployment in Agriculture, MPL=0 if not negative

Arthur Lewis: MPL in Agriculture is Zero in Underdeveloped countries

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Law of Diminishing Marginal Returns

Easily confused with negative returns decreases in output
Explains a declining marginal product, not necessarily a negative
one
Additional output can be declining while total output is increasing

Assumes a constant technology

Changes in technology will cause shifts in the total product curve
More output can be produced with same inputs
Labor productivity can increase if there are improvements in
technology, even though any given production process exhibits
diminishing returns to labor

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Third stage of Production: Negative Returns

Use of more and more of variable Factor can lead to negative
Marginal product of variable factor and Decline in Total Output.
Ex: Over dosage of Fertilizer on a fixed plot of land can reduce
productivity of land.

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Production Function with Two Variable Inputs:

Long Run
In Long Run Firm can produce Output by Combining different
amounts of Labor and Capital
All possible combinations of inputs that yield the same output can be
represented by a curve: ISOQUANT

An isoquant is a contour, which contains

all input combinations yielding production
of same output
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Relevance of Isoquant Model

Isoquant reflects FLEXIBILIITY of a firm in CHOOSING
use of INPUTS while making Production Decision.
Isoquant facilitates Choosing Input Combination that
MINIMIZES COST and Maximize Profit. Compare cost
and benefit while using Inputs.
Ex: For office Automation, Consider Trade-off between Secretaries
and Employing Computer
Ex: To get rid of shortage of young low wage employees companies
have responded by automatingAdding self service salad bars and introducing more sophisticated
cooking equipment-Pindyck et al.
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Isoqunant

Table shows Maximum amount of output that can

be produced with each combination of INPUTS in
a year
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Isoquant Map
E

Capital 5
per year

Ex: 55 units of output

can be produced with
3K & 1L (pt. A)
OR
1K & 3L (pt. D)

4
3

2
q3 = 90
D

q2 = 75
q1 = 55

1
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Labor per year

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Diminishing Returns
Capital 5
per year

Increasing labor
holding capital
constant (A, B, C)
OR
Increasing capital
holding labor constant
(E, D, C

4
3

C
D

q3 = 90
E

q2 = 75
q1 = 55

1
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Labor per year

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Diminishing Marginal Returns

Holding Capital at 3 and Increasing Labor from 0 to 1 to 2 to 3
Output increases at a decreasing rate [0, 55, 20 (=75-55), 15
(=90-75)]
Implication: Diminishing marginal returns from labor in the
short run and long run
Holding labor constant at 3 increasing capital from 0 to 1 to 2 to 3
Output increases at a decreasing rate (0, 55, 20, 15)
Due to diminishing returns from capital in short run and long
run

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How to Substitute Inputs (MRTS)

COMPANIES MUST DECIDE WHAT COMBINATION OF INPUTS
(Lab. or Cap.) TO USE TO PRODUCE A CERTAIN QUANTITY OF
OUTPUT
There is a TRADE-OFF between inputs: Use more of one input
and less of another for the same level of output
Slope of the isoquant: Shows how one input can be substituted
for the other and keep the level of output the same.
Marginal Rate of Technical Substitution (MRTS): The negative
of the slope of ISOQUANT
MRTS: Amount by which the quantity of one input can be
reduced when one extra unit of another input is used, so that
output remains constant
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Marginal Rate of Technical Substitution (MRTS)

Marginal Rate of Technical Substitution (MRTS) is the rate at which
one input can be substituted for another without changing the
production of output.
MRTSLK: Amount by which Input capital is reduced when one extra unit of labour is
6
used, so that output remains constant

MRTS LforK

K
dK
= (1)
= (1)
L
dL

_ Change in Capital Input

Change in Labour Input

CAPITAL

INCREASED QUANTITY

4
3

1
0
1

LABOR
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Marginal Rate of
Technical Substitution
Capital
per year

Negative Slope measures

MRTS;
MRTS decreases as move down
the Isoquant curve

1
1

2/3

Q3 =90

1
1/3

Q2 =75

Q1 =55
1
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Labor per month

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MRTS & Marginal Product

Output remains
constant as we are
moving along the
Isoquant.
Net effect of
increasing labor and
decreasing capital
must be zero

(MPL )(L)+(MPK )(K)=0

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Using changes in
output from capital
and labor we can see
(MPL )( L) + (MPK )( K) = 0
(MPL )(L) = - (MPK )( K)
(MPL )
K
=
= MRTS
( MPK )
L

Inference: Marginal rate of

Technical Substitution between
two inputs is equal to ratio of
Marginal products of two inputs
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Changes in Output in Long Run: Returns to

Scale
How does a firm decide the best way to increase output in the long run?
Can change the scale of production by increasing all inputs in
proportion
If double inputs, output will most likely increase but by HOW
MUCH?

Returns to scale refers to the degree by which

output changes as a result of a given change in the
quantity of all inputs used in production (Salvatore, P.262).
Caution: Returns to scale is applicable in the long run while
increasing/decreasing returns can be used in the short run.

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Returns to Scale

Aims at examining change in SCALE of Operation on Output

Production shows increasing, decreasing or constant returns to scale when a
balanced increase in all inputs leads to a more-than-proportional, less-thanproportional, or just-proportional increase in output.

If output changes are more than proportionate change in

all inputs- increasing returns to scale.
Exp: Technical or Engineering Characteristics of Production Process: Double Radius of a pipe
line carrying water (or industries with production process involving flow of liquids through
pipeline). Let COST of PIPE increased TWICE due to increase in RADIUS by TWO times. The
Circumference also doubled. But the carrying capacity went up by 4 times as the volume
quadruples).
Ware House: Four fold increase in Surface Area of Wall and Floor of the Warehouse will lead
increase in Volume by 8 times.

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Returns to Scale
Constant Returns
to Scale

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Increasing Returns
to Scale

Decreasing
Returns to Scale

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Why does Increasing Returns Arise?

Larger scale of operation leads to SPECIALISATION and
improvement in PRODUCTIVITY
(of the managers and workers in their respective assigned task).
Makes them comfortable to use more SOPHISTICATED EQUIPMENT
and hence improvement in Output.

Ex: Assembly line Automobile Industry (specialisation and increasing Returns)

Implication for Public Policy:
Increasing Returns provides justification to have one large firm rather than number
of small firms as the former is ECONOMICALLY ADVANTAGEOUS (relatively low
cost).

Improvement in Efficiency leads to selling product at LOWER PRICE

Hence, feasible to Increase Market Share by competing with contenders
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Constant Returns to Scale

If output changes exactly proportional to a given

proportion of change in all inputs- constant returns
to scale.
(If both inputs will be doubled then output will be doubled)

Ex- A large Travel Agency provides the same service per client and use
same ratio of capital (office space) and labour (travel agents) as a
small agency that services fewer clients-Pindyck et al.
Implication: Productivity of the factors of Production does not change with
change in Size of Firms. (Two plants can produce twice of what is
produced in one plant)
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Decreasing Returns to Scale

A balanced increase in all inputs leads to less than proportional

increase in total output- Decreasing returns to scale.

Why does it Emerge?

In many processes, scaling up may eventually reach a point beyond which inefficiencies set
in..Can arise because costs of management or control become large (Samuelson &
Nordhaus).
Difficulties in organizing and running large scale operations can lead to decrease in
productivity of labour and capital.
BREAKDOWN OF COORDINATION AND INFORMATION FLOWS
(difficult in Maintaining useful line of communication between Management and Workers)

Ex: IF ELECTRICITY GENERATION PLANT GROWS TOO LARGE, RISK OF PLANT

FAILURE BECOMES MORE PRONOUNCED.
Ex: General Motors had to downsize of oversize firms as Cost of Control outweighed Increased
Returns to Scale from Specific Plant during the 1990s.
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Isocost Lines

PK =
Re1/unit K

PL =
Re 2/unit L

The cost equation is:

Isocost lines represent
all combinations of two
inputs that a firm can
purchase with the same
TOTAL COST.

CO = PK ( K ) + PL ( L)
With constant cost
(Slope of Isocost):

7
6
Input K (units)

INCREASED COST

5
4
3
2
1
0
0 0.5 1 1.5 2 2.5 3 6

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P
K

= L = 2
PK
L

Input L (units)
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How to Determine Optimal Combination of Inputs:

Producers Equilibrium
How to CHOOSE BEST COMBINATION of INPUTS to produce a
GIVEN level of OUTPUT?
Producers objective: Maximize output given TOTAL OUTLAY.
or Minimize Cost given the level of output to be produced
Choose a Technically Efficient Combination to Produce given Level of Output, given the
Constraint imposed.
Choice of Combination needs to satisfy:
Combination must be Technically Efficient (lie on the Relevant Isoquant)
Combination to satisfy cost Constraint (lie on Isocost Line)
Choose the input combination in such a way that the isocost line corresponding to given
level of expenditure (cost) touches the HIGHEST isoquant possible.
The point is where ISOCOST line is tangent to ISOQUANT-Economical Least-Cost
Combination
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The tangent point between an

isocost and an isoquant
represents least cost.
With constant cost:
PL
K
=
PK
L

With constant quantity

(MRTS):
MP
MP

L
K

K
=
L

Input K (units)

Least-Cost Combination
Producers Equilibrium
8
7
6
5
4
3
2
1
0

this is the leastcost combination

0.5

Therefore at the leastcost combination

(Slope of Isoquant=Slope of Isocost line:
MPK MPL
=
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PK
PL

1.5

2.5

Input L (units)

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Producers Equilibrium.
Interpretation:
MARGINAL PRODUCT OF LAST RUPEE SPENT ON LABOUR IS THE SAME AS
THE MARGINAL PRODUCT OF LAST RUPEE SPENT ON CAPITAL

Firms employing least cost combination of inputs L and K

reveals that additional output (Marginal Output) obtained
from spending additional Rupee on input L must be equal
to additional output obtainable from spending additional
rupee on input K (Truett and Dale B Truett).

MP K
MP L
=
PK
PL
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