Production Analysis

What is production?
Factors of production
Production function with one variable
Production function with two variables
Economies of scale and scope

Production
Production - an organized activities of converting
inputs into output or creation of value and utility
Factors of production

Rewards

Land

- rent

Labor

- wages

Capital

- interest

Organization

- profit

Production function
Production function
The functional relationship between physical inputs
and physical output

What do Tata Motors, Reliance Power and SBI , have

in common?
Like every firm,

They must decide how much to produce.

How many people to employ.

How much and what type of capital

equipment to use.

How do firms make these decisions?

Production decisions of the firm

Three Steps:
Production Technology
Cost constraints
Input choices

Law of diminishing marginal

productivity
as more and more of a variable input is

added to an existing fixed input, after

some point the additional output one gets
from the additional input will fall.

This means that initially the production function

exhibits increasing marginal productivity

Then it exhibits diminishing marginal productivity.

Finally, it exhibits negative marginal productivity

Production Function
With One Variable Input

Total Product
Marginal Product
Average Product
Production or
Output Elasticity

TP = Q = f(L)
TP
MPL =
L
TP
APL =
L
MPL
EL =
APL

Production Function
With One Variable Input

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

Production Function
With One Variable Input

Production Function
With One Variable Input

Optimal Use of the

Variable Input

Marginal Revenue
Product of Labor

MRPL = (MPL)(MR)

Marginal Resource
Cost of Labor

TC
MRCL =
L

Optimal Use of Labor MRPL = MRCL

Optimal Use of the

Variable Input

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

Optimal Use of the

Variable Input

Production With Two

Variable Inputs

Isoquants

Isoquants show combination of two inputs that

can produce the same level of output.

Properties of Isoquant
Downward sloping
Two isoquants never intersect
Convexity

- MPlabour / MPcapital = - MPL / MPK = K / L

The slope of the isoquant is called the marginal rate
of technical substitution which can be defined as
the rate at which a firm can substitute capital for
labour and hold output constant.

Isoquants Showing All Combinations of

Capital and Labour That Can Be Used to
Produce 50, 100, and 150 Units of Output

The Slope of an Isoquant Is

Equal to the Ratio of MPL to MPK

Isocosts
Isocost lines represent all combinations of two
inputs that a firm can purchase with the same
total cost.

C wL rK

C w
K L
r r

Isocost Lines Showing the Combinations

of Capital and Labour Available for $5,
$6, and $7

Isocost Line Showing All Combinations

of Capital and Labour Available for $25
The slope of an
isocost line is
equal to - PL / PK.
The simple way to
draw an isocost is
to calculate the
endpoints on the
line and connect
them.

The Cost Minimizing Equilibrium

Condition
Slope of isoquant = - MPL / MPK
Slope of isocost = - PL / PK
For cost minimization we set these equal
and rearrange to obtain:

MPL / PL = MPK /
PK

Finding the Least-Cost Combination of

Capital and Labour to Produce 50 Units
of Output
Profit-maximizing
firms will minimize
costs by producing
their chosen level of
output with the
technology
represented by the
point at which the
isoquant is tangent to
an isocost line.
Point A on this
diagram

Minimizing Cost of Production for

qx = 50, qx = 100, and qx = 150
Plotting a series
of costminimizing
combinations of
inputs - shown
here as A, B and
C - enables us
to derive a cost
curve.

Expansion path

Returns to Scale
Measuring the relationship between the
scale (size) of a firm and output
1) Increasing returns to scale: output
more than doubles when all inputs
are doubled

Larger output associated with lower cost (autos)

One firm is more efficient than many (utilities)

The isoquants get closer together

Returns to Scale
Measuring the relationship between the
scale (size) of a firm and output
2) Constant returns to scale: output
doubles when all inputs are doubled

Size does not affect productivity

May have a large number of producers

Isoquants are equidistant apart

Returns to Scale
Measuring the relationship between the
scale (size) of a firm and output
3) Decreasing returns to scale: output less
than doubles when all inputs are doubled

Decreasing efficiency with large size

Reduction of entrepreneurial abilities

Isoquants become farther apart

Returns to Scale
Constant
Returns to
Scale

Increasing
Returns to
Scale

Decreasing
Returns to
Scale

Economies of scale and scope

Internal economies
External economies

Internal economies

Labor economies
Managerial Economies
Financial economies
Marketing economies
Technical economies
Risk and survival Economies

External economies

Economies of localization
Economies of information
Economies of vertical disintegration
Government policies
Economies of byproduct

Basic cost concepts

Explicit cost and Implicit cost

Opportunity cost
Marginal cost and incremental cost
Real cost
Controllable cost
Traceable cost and common costs
Sunk cost
Social cost
Fixed cost and variable cost

Short-Run Cost Functions

Total Cost = TC = f(Q)

Total Fixed Cost = TFC
Total Variable Cost = TVC
TC = TFC + TVC

Short-Run Cost Functions

Average Total Cost = ATC = TC/Q

Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = TC/Q = TVC/Q

Short-Run Cost Functions

Q
0
1
2
3
4
5

TFC
$60
60
60
60
60
60

TVC
$0
20
30
45
80
135

TC
$60
80
90
105
140
195

AFC
$60
30
20
15
12

AVC
$20
15
15
20
27

ATC
$80
45
35
35
39

MC
$20
10
15
35
55

Long-Run Cost Curves

Long-Run Total Cost = LTC = f(Q)
Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = LTC/Q

Long-run average cost curve

Learning Curves

Learning and costs

Job familiarization and less time to instruct
workers
More skillful movements of workers
Better operation sequences, machine-feeds and
speeds
Less rejection and rework
Manufacturing lots are larger, cutting down the
set-up time proportion
Improved coordination and management controls

Tools of cost control

Budgetary control
Standard Costing
Ratio analysis
Value analysis

Areas of cost control

Material cost
Labour cost
Overhead cost
Selling cost

Cost-Volume-Profit Analysis
Total Cost-Volume-Profit Analysis Revenue =
TR = (P)(Q)
Breakeven Volume TR = TC
(P)(Q) = TFC + (AVC)(Q)
QBE = TFC/(P - AVC)

Cost-Volume-Profit Analysis

Operating Leverage

Break Even Analysis

TR = TC
In units BEP = TFC/CM
In value BEP = TFC/ P.V.Ratio

Managerial Applications of BEP

Price and Cost decision

Target Profit
Margin of safety
Product mix decision
Selection of technology
Decision on promotional expenditure
Make or buy decisions