Production Analysis

Prof Prema Basargekar

 Introduction
Basic

concepts
Production function with one variable
Optimal use of the variable input
Production function with two varible
inputs
Optimal combination of inputs
Returns to scale
Innovation process

Production and cost belong to supply side

economics.
The core concern and survival of the firm is to
become competitive, both in terms of price and
quality.
Managers try to minimize cost and optimize
production within given resources(inputs).

 How

can production be optimized or cost

minimized.
How does output behave when quantity of
inputs is increased? How does technology
matter in reducing the cost.
How can the least-cost combination of
inputs be achieved.
Given the technology what happens to the
rate of return when more plants are
added to the firm.

Production : Transformation of inputs or resources into

outputs of goods & services. It refers to all activities
involved in production of G &S, from borrowing to set up
plant to running quality control to market G & S.
Inputs: All the resources used in the production of G & S Labor, Capital, Land, mgmt, technology, entrepreneur,
information
Fixed Inputs: Those which cannot be changed during a
time period under consideration such as Plant, machinery,
permanent staff (K)
Variable Inputs : Those which can be varied easily & on a
very short period of timem such as Raw material, Casual
labour which can vary according to the output (L)

 Short

At least one input is fixed

Long

Run

Run

All inputs are variable

Short run / Long run is relative & differs from
industry to industry
The importance of FOPs is also relative

Production function is an equation, table or graph

showing the maximum output of a commodity that a
firm can produce per period of time with each set of
inputs.
Inputs & outputs are measured in physical qty rather
than in monetary units.
Technology is assumed to be constant.
Q = f(X, Y) = XY
If Q = 2X + 7Y; then if X = 10 & Y = 7; then Q = 70
Q = f(L, K)

In the short run the input output relationship is

studied with one variable input & other inputs
considered as constants. It is also known as Laws of
Variable Proportions or Laws of Returns to Variable
Inputs or Law of Diminishing Returns or Laws of
Return to Factor.
Assumptions:
A. Technology is constant
B. Labour is homogeneous
C. Input prices are given

Q = f(L, K)
K
6
5
4
3
2
1

Q
10
12
12
10
7
3
1

24
28
28
23
18
8
2

31
36
36
33
28
12
3

36
40
40
36
30
14
4

40
42
40
36
30
14
5

39
40
36
33
28
12
6 L

Discrete Production Surface

Eg. Sachin Tendulkars score:

Total runs in 3 Matches: 150
Average runs : 50
Runs scored in 4th match: 70
Total runs : 150 +70 = 220
Average runs : 220/4 = 55
Marginal runs : 220-150=70
Runs scored in 5th match = 40
Total runs: 220+40 = 260
Average runs : 260/5 = 52
Marginal runs : 260-220 = 40

 When

average is rising, marginal is above

the average.
When average is falling, marginal is below
the average.
When average remains constant, marginal
and average are equal to each other.

Total Product
Total product is whole output.
Marginal product is the change in output caused
by increasing any input X.
If MPX=Q/X> 0, total product is rising.
If MPX=Q/X< 0, total product is falling (rare).
Average product
APX=Q/X.

Returns to a Factor
Shows what happens to MPX as X usage grows.

MPX> 0 is common.
MPX< 0 implies irrational input use (rare).

Diminishing Returns to a Factor Concept

MPX shrinks as X usage grows, 2Q/X2< 0.
If MPX grew with use of X, there would be no
limit to input usage.

Total Product

TP = Q = f(L)

TP
L

Marginal Product

MPL =

Average Product

TP
APL =
L
MPL
EL = AP
L

Production or
Output Elasticity

Total, Marginal, and Average Product of Labor, and Output Elasticity

L
0
1
2
3
4
5
6

Q
0
3
8
12
14
14
12

MPL
3
5
4
2
0
-2

APL
3
4
4
3.5
2.8
2

EL
1
1.25
1
0.57
0
-1

LDR postulates that production undergoes three

stages
Stage 1 of production refers to the rate of increase
in average product of the variable input up to the
pt where AP & MP are equal.
Stage 2 is the range of maximum average product
of the variable input to where the marginal product
of the input is zero
Stage 3 of the production refers to the negative
range of marginal product of the variable input

 As

the fixed factor capital has some given

capacity, it gets better utilised as we go
on increasing the variable input labour.
In this process because of division of
labour the productivity of the labour also
increases.
Once the maximum capacity of the
capital is utilised further increase in
labour results in fall of production.

Stage I of the production states that MP of labour

is rising; thus it will help firm to increase the
production by increasing L.
Stage III of the production states that MP of
Labour is negative. Hence even if labour is
available free of cost, rational producer will not
operate in this stage.
Stage II of the production states that MP of L & C
are positive but is declining; the stage in which
the rational producer will operate. The point at
which he will operate will depend on prices of
inputs & prices of outputs.

well known economist Thomas Malthus

believed in the law of diminishing returns
from agriculture. Because land is limited in
quantity and marginal and average
productivity of labour would always fall, the
agriculture production would not be
sufficient to feed rising population and
eventually it would lead to mass starvation.
Fortunately Mathus was proved wrong
technological improvements in agriculture
increased land and labour productivity
multiple times.

 How

much labour the firm should employ?

As long as extra revenue generated from the
sale of the output exceeds extra cost of
hiring the labour.
MRPL = Extra revenue generated by use of
additional unit of labour
MRCL = Extra cost of hiring additional labour

Marginal Revenue
Product of Labor
Marginal Resource
Cost of Labor

MRPL = (MPL)(MR)
MRCL =

TC
L

Optimal Use of Labor MRPL = MRCL

Use of Labor is Optimal When L = 3.50

L
2.50
3.00
3.50
4.00
4.50

MPL
4
3
2
1
0

MR = P
$10
10
10
10
10

MRPL
$40
30
20
10
0

MRCL
$20
20
20
20
20

LDR addresses questions such as how much to

produce and what no. of variable inputs to apply
to a given fixed income.
In stage 3, labour capital ration is very high which
suggests that additional employment of labour is
not desirable.
In stage 1, since capital is underutilised firm can
increase the labour input to optimise its
production.
Whereas stage second provides the best
opportunity to the firm to determine its level of
production.

Maruti Udyog Ltd. Has a physical capital stock valued

at about Rs. 144.5 Crs. About 4004 workers are
employed to use this employment of labour?
In general, to maximise profits, the firm should hire
labour as long as the additional revenue associated
with hiring of another labour exceeds the cost of
employing that labour.
For instance, if marginal product of additional labour
is two units of output (two cars) and each unit is
worth Rs. 2 lakh. The additional revenue is Rs. 4
lakh. If additional cost of employing is Rs. 3 lakh,
then the firm can and should employ him or her. If
additional cost is Rs. 4.5 lakh, the firm should not
employ him/ her.

 In

the long run both the inputs viz L & C

are variable.
The Supply of both the units is elastic &
firms can hire larger quantities ofboth the
inputs.
The technological relationship between
both the inputs is given by Laws of
Returns to Scales

10

24

31

36

40

39

12

28

36

40

42

40

12

28

36

40

40

36

10

23

33

36

36

33

18

28

30

30

28

12

14

14

12

6
L

Isoquants show combinations of two

inputs that can produce the same level
of output.
Firms will only use combinations of two
inputs that are in the economic region of
production, which is defined by the
portion of each isoquant that is negatively
sloped.

Isoquants

Economic
Region of
Production

 Marginal

Rate of Technical Substitution:

Isoquatnt has a negative slope in the
economic region; or the region in which
substitution between two inputs is
possible.
The negative slope implies that if one
input is reduced, the other input has to
be so increased that the total output
remains unaffected.

 The

manger can choose from among various

different combinations of K and L.
The optimal combination is one which
maximises the output with the lowest cost.
This combination comes where MP divided by
input price is same for all inputs used.
=

MPl/Pl = MPk/Pk or MPl/w = MPk/r

 Suppose

C = 100K + 250L
Budget is Rs. 1500
Thus 1500 = 100K + 250L
Thus K = 15 2.5L
If budget increases to Rs. 2000
Then K = 20 2.5L
If relative factor prices change, the slope of
isocost line will change.

Farmers in USA & Canada usually use more

capital intensive technology as compared to
farmers in India & China where more labour
intensive technology is used.
This means that the same quantity of foodgrain
(eg wheat) can be produced either with using
more capital or more labour.
Suppose the isoquant showing an output of
10,000 quintals is using L of 500 hours & K of 100
machine hours. If the farmer decides to
experiment with using 90 hours of machine and
he needs to replace this machine with 260 hours.
It means MRTS is equal to 0.04(-10/260 = 0.04)

Production Isoquants
Show efficient input combinations.
Technical efficiency is least-cost production.

Isoquant shape shows input substitutability.

Straight line isoquants depict perfect substitutes.
C-shaped isoquants depict imperfect substitutes.
L-shaped isoquants imply no substitutability.

Marginal Rate of Technical Substitution

Shows amount of one input that must be
substituted for another to maintain constant
output.
For inputs X and Y, MRTSXY=-MPX/MPY
Rational Limits of Input Substitution
Ridge lines show rational limits of input
substitution.
MPX<0 or MPY<0 are never observed.

Isocost lines represent all combinations of two

inputs that a firm can purchase with the same
total cost. By using Isocost & Isoquant a firm
can determine the optimal input combination to
maximise the profits.
C Total Cost
C wL rK

w Wage Rate of Labor ( L)

C
r

w
L
r

Cost of Capital ( K )

MRTS = w/r

 Suppose

a firm is using two inputs K and L.

MPl = 5 and MPk = 40.
The prices of inputs are Pl = Rs. 5 and Pk =
Rs. 25.
Is the firm optimizing the use of its
resources? If not explain.

 Here

MPl/Pl = 1 and MPk/Pk = 1.6

MPl/Pl < MPk/Pk
So the firm would be better of by using less
labour and more capital.
If the firm spends additional Rs. 25 on labour
it gain less than 25 units of output.
But if it spends additional Rs. 25 on capital it
would gain 40 units of output.

Budget Lines
Show how many inputs can be bought.
Least-cost production occurs when MPX/PX =
MPY/PY and PX/PY = MPX/MPY
Expansion Path
Shows efficient input combinations as output
grows.
Illustration of Optimal Input Proportions
Input proportions are optimal when no additional
output could be produce for the same cost.

Production Function Q = f(L, K)

Q = f(hL, hK)
If

= h, then f has constant returns to scale.

If

> h, then f has increasing returns to scale.

If

< h, the f has decreasing returns to scale.

Constant
Returns to
Scale

Increasing
Returns to
Scale

Decreasing
Returns to
Scale

Economic Productivity
Productivity growth is the rate of change in
output per unit of input.
Labor productivity is the change in output per
worker hour.
Causes of Productivity Growth
Efficiency gains reflect better input use.
Capital deepening is growth in the amount of
capital workers have available for use.

 Product

Innovation
Process Innovation
Product Cycle Model
Just-In-Time Production System
Competitive Benchmarking
Computer-Aided Design (CAD)
Computer-Aided Manufacturing (CAM)

Units of labour

Total Product

Avg Product

40

2
3

48
138

44

5
6
7
8

Mar Product

24
210
29
-27

 Production

function for an agricultural

commodity is
TP = 15L2 L3
A.

How much labour (L) should be employed

to maximise the output?

B. What is the value of MPL when TP is at

maximum?

 TP

is maximised when MPL = 0

= TP/ L = 30L 3L2 = 0
= L (30 -3L) = 0
= L = 10
Output
MPL

is maximum when L = 10

is zero when TP is maximum.

 Production

function
Short run and long run production function
Law of variable proportions/ Law of
diminishing returns/ Law of returns to
variable inputs
Law of returns to scale
Isoquant & isocost
Marginal rate of technical substitution
Increasing, constant & decreasing returns to
scale