PRODUCTION ANALYSIS

Learning Outcomes

• After reading this topic, you are expected to learn about:

• The relationship between inputs and output in the short run
with the help of law of variable proportions.
• The relationship between inputs and output in the long run with
the help of law of returns to scale
• Clarify, all these concepts with the help of a case study
 DEFINITION OF PRODUCTION

• Definition
– Production is the process of transforming inputs into
outputs.

INPUTS OUTPUTS

Inputs refers to the Refers to what we

factors of production get at the end of the
Processing
that a firm use in the production process
production process. that is finished
products.
 LAND LABOUR
All natural resources Physical or mental
or gift of nature activities of human beings

CLASSIFICATION
OF FACTORS
OF PRODUCTION

CAPITAL ENTREPRENEUR
Part of man-made wealth A person who combines the different
used for further production factors of production, and initiates
the process of production and also
bears the risk
 PRODUCTION FUNCTION

Q = Output Q = (N,L,K, E)
N= Land
K = Capital
L = Labour
E = Entrepreneur
 SHORT-RUN AND LONG-RUN PRODUCTION
FUNCTION

• Two Types of Factor Inputs

– Fixed Input
– Variable Input
• Time Period
– Short run
– Long run
 SHORT-RUN PRODUCTION FUNCTION

Q = ( K , L)
Where: Q = Output
L = Labor
K = Capital (fixed)
Production Function with One Variable Input

Total Product TP = Q = f(L)

TP
Marginal Product MPL =
L
Average Product TP
APL =
L
SHORT-RUN PRODUCTION FUNCTION (cont.)

Capital Labour Total Marginal Average Stages of

(Fixed (Variable Product Product Product Production
input) input)
10 0 0 0 0
10 1 8 8 8
10 2 20 12 10 STAGE I
10 3 33 13 11
10 4 44 11 11
10 5 50 6 10
10 6 54 4 9
STAGE II
10 7 56 2 8
10 8 56 0 7
10 9 54 -2 6
STAGE III
10 10 50 -4 5
MP = 54 - 56 AP = 56
9-8 8
= -2 = 7
 SHORT-RUN PRODUCTION FUNCTION

Stage I
 Proportion of fixed factors are
greater than variable factors
 Under utilization of fixed factor
 Operation involves a waste of resources
Stage II
 Called law of diminishing returns
 The most efficient stage of production
because the combinations of inputs are fully
utilized

STAGES OF PRODUCTION

Stage III
 Proportion of fixed factors is lower than variable factors
 Increase in variable factors decline the TP because of overcrowding
 A producer would not like to operate at this stage
Question????
Why diminishing return operates?
Can we postpone the diminishing returns to a
factor?
 MCQ
1. An example of a variable resource in the short run is:
A) Labour B) capital equipment.
C) land. D) a building.
2. A cost that has already been made and cannot be recovered is called as:
A) marginal cost. B) fixed cost. C) variable cost. D) sunk cost.
3. The long run is a time frame in which:
A) the quantities of all resources are fixed.
B) the quantities of all resources can be varied.
C) the quantities of some resources are fixed and the quantities of other resources can
be varied.
D) all costs are sunk costs.
4. The average product of labor is……………
A) the inverse of the average product of capital.
B) total product divided by the total quantity of labor employed.
C) the slope of the curve showing the total product of labor.
D) the slope of the curve showing the marginal product of labor.
5. Average product is the:
A) maximum output attainable with fixed factors and one variable factor.
B) total product per unit of an input.
C) change in total product due to a one unit change in input.
D) total product divided by the total cost.
 Optimal Use of the Variable Input

Marginal Revenue
MRPL = (MPL)(MR)
Product of Labor
Marginal Resource TC
MRCL =
Cost of Labor L

Optimal Use of Labor MRPL = MRCL

Long Run Production Function
 Production Function with Two Variable Inputs
Capital Labour (’00 MRTS
 All inputs are variable in long run (Rs.
crore)
units)
and only two inputs are used
40 6 -
28 7 12:1
Q  f ( L, K ) 18 8 10:1

45
40

Capital (Rs. Crore)

35
30
25
20
15
10
5
0
6 7 8 9 10
Labour ('00 units)
 Marginal Rate of Technical Substitution

 Measures the reduction in one input, due to unit increase in

the other input that is just sufficient to maintain the same
level of output.
K
MRTS LK 
L
 MRTS of labour for capital is equal to the slope of the
isoquant.
 Characteristics of Isoquants

 Downward sloping

 Convex to the origin

 A higher isoquant represents a higher output

 Two isoquants do not intersect

 Isoqunats can not start from y-axis or x-axis

 Special Shapes of Isoquants
Factor 2 Factor 2

Q3
Q2
Q1
Q1 Q2 Q3
O O
Factor 1 Factor 1

Linear isoquants Right angled isoquants

• Perfect substitutability • Capital is a perfect complement

between two factors for labor
• Gasoline and oil used to • Non existence of any
substitutability between the two
operate heating furnaces factors
• Fish meal and Soybeans • Engines and body part of the
to provide protein in a feed automobile
mix.
 Iso-cost Line

. C  wL  rK

C  Total Cost
w  Wage Rate of Labor ( L)

r  Cost of Capital ( K )
 Changes in Factor Price Line

• Change in price of factor inputs

• Change in resources
 Producer’s Equilibrium

Two conditions must be satisfied:

a) IQ must be convex to the origin
b) Slope of IQ= Slope of Iso-cost line

MRTSLK = PL / PK
 Expansion Path

“Expansion path is that line which reflects least cost

method of producing different levels of output,
when factor prices remain constant”
 Returns to Scale

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, then f has decreasing returns to
scale. © Oxford University Press,
2016. All rights reserved.
 SCALE OF PRODUCTION

INCREASING RETURNS TO SCALE

Capital

200
IQ = 60
100%

> 100%
100
IQ =20

Labour

100 200
100%
 SCALE OF PRODUCTION

CONSTANT RETURNS TO SCALE

Capital

200
IQ = 40
100%

100%
100
IQ =20

Labour
100 200

100%
 SCALE OF PRODUCTION (cont.)

DECREASING RETURNS TO SCALE

Capital

200
IQ = 30
100%

100
< 100%
IQ =20

Labour
100 200

100%
© Oxford University Press,
2016. All rights reserved.
• When a firm doubles its inputs and finds that its
output has more than doubled, this is known as:
A. constant returns to scale.
B. Increasing returns to scale.
C. Diminishing returns to scale.
D. All of these
Which of the following is not true about isoquant…….
A. Isoquant is concave
B. Isoquant is convex
C. Isoquant is downward sloping
D. Isoquant cannot cross
The right angle isoquant is related to ………
A. Substitute factor inputs
B. Complementary factor inputs
C. Diminishing MRTS
D. None of these
When the total product curve is falling, the:
A. marginal product of labor is zero.
B. marginal product of labor is negative.
C. average product of labor is increasing.
D. average product of labor must be negative.
• The law of diminishing returns states that:
A. as a firm uses more of a variable resource, given the quantity of fixed
resources the average product of the firm will increase.
B. as a firm uses more of a variable resource, given the quantity of fixed
resources, marginal product of the firm will eventually decrease.
C. in the short run, the average total costs of the firm will eventually
diminish.
D. in the long run, the average total costs of the firm will eventually
diminish
Empirical Production Functions

Cobb-Douglas Production Function

Q = AKaLb

Estimated Using Logarithms

Log Q = Log A + a Log K + b Log L

.
©
 Global Competitiveness Index (Business
Standard)

Global Competitiveness Index (GCI), which is based

on a country-level data covering 12 categories.
These include institutions, infrastructure,
macroeconomic environment, health and primary
education, financial market development,
technological readiness, market size, business
sophistication and innovation.
India Ranked 39th spot in the Global
Competitiveness Index in 2016-17.
India, which ranked 55th last year, registered the
sharpest improvement among 138 countries
assessed.
India is now the second-most competitive country
amongst the five-nation BRICS bloc, behind China,
which is at the 28th spot.
According to the Index, Switzerland ranks as the
most competitive nation, followed by Singapore
and the US. The Netherlands and Germany are at
the fourth and fifth spots, respectively.
 The Innovative Process

Innovation is the single most important

determinant of firm’s long-term competitiveness at
home or aboard.
 Basic Types of Innovations

1. Product Innovation: (Introduction of new or

improved product)
2. Process Innovation: (Introduction of new or
improved production process)
• Unless a firm aggressively and continuously
improves the product or production process it will
be inevitably be overtaken by the other more
innovative firm?

Examples????????????
 What is required?

• Introduction of a new product /Concept is more

likely to succeed than changing an existing product.

(McDonald’s hamburgers and Apple i-pods ) >

(Introduction of a new soup, cheese or biscuits
globally).
What are the risks in the innovations?
 Examples

• RJR Nabisco Inc- “Smokeless cigarette”

• Coca cola’s change of its 99 year old recepie
 A Case-Study of Philips

• Philips was the first to develop HDTV, but HDTV

become successful after sufficient programming for
it.
• But this occurred after Philips took $ 2.5 billion
write down and abandoned the filed, which allowed
LG and Samsung to market HDTV.
 A case of Michelin’s Run flat
Invention
• Michelin’s introduced a tire that would run up to
125 miles after being punctured-thus preventing
dangerous highways blowouts or emergency pull-
overs.
• But it was not able to become a successful
innovation because garages were not equipped to
service the new tires.
• For a innovation to be successful, the firms must
make sure that all parts of the innovative
ecosystem are in place before it introduces the
innovation.
 Types of Innovative Model

Closed Innovative model

Open Innovative model
What are the benefits of open innovation?
 Procter & Gamble: A Real Case of Open
Innovation Model
Started Open Innovation in 2005
By 2007, 50 percent of its innovations from outside
of the company
Spin brush of P&G was the best selling toothbrush
in United States, developed not in their labs but by
four Cleveland Entrepreneurs.
 Examples of Open Innovation Model

Photo Copiers
Computers
Disk drives
Semiconductor
Telecommunications
Pharmaceuticals
Biotechnology
 Homework

 Case Study Policies to Drive Innovation in

India (pp.279)
The New U.S. Digital Factory
© Oxford University Press,
2016. All rights reserved.
Cost Analysis
Application of cost optimization
techniques in Industry
 How ICICI Bank leveraged software
robotics to reduce response time to
customers by 60 % and lower cost of
operations
Simply put, software robotics also known as Robotic Process
Automation (RPA) is a technology that automates routine,
standardized and repetitive business processes performed by
the employees by the technology.
Process automation is the latest buzzword in the IT industry as
technology service providers come up with new offerings for
the untapped market.
In sync with this idea, ICICI Bank has become the first bank in
the country and among the few globally to deploy software
robotics to power its internal banking operations.
• The software robots are processing over 10 lakh transactions daily, bringing in
greater operational efficiency, higher accuracy and a massive reduction in
processing time for customer services and lower average cost.
• Software robots have reduced the response time to customers by up to 60 % and
increased accuracy to 100%, thereby improving the by the bank's productivity and
efficiency. It's freeing up the resources used to do mundane tasks.
• It has enabled our operations team to focus on other value-added and customer-
related functions.
• From a customer perspective, we've seen benefits of better service and faster
turnaround time. From an organizational perspective, we've witnessed better
resource utilization and increased operational efficiency. It almost brings in a
straight through processing.
•
 Introduction

• Cost is defined in simple terms as a sacrifice or foregoing which has

already occurred or has potential to occur in future with an objective to
achieve a specific purpose measured in monetary terms.

• Some of the determinants of cost:

– Price of inputs
– Productivity of inputs
– Technology
– Level of output
 Kinds of Costs
 Accounting Cost/ Explicit Cost
 Implicit Cost
 Opportunity Cost
 Economic Cost
 Replacement Costs
 Social Costs
 Controllable Costs (fringe benefits to employees, costs of
quality control) and Uncontrollable Costs
 Production Costs and Selling Costs
 Costs in Short Run
Costs

• Fixed Costs

C TFC – Do not vary with output; e.g.

plant, machinery, building.

O
Quantity
 Costs in Short Run
 Variable Costs
 Costs that vary with level of
output e.g. cost of raw
materials, wages.
 TVC may be an inverse S
shaped upward sloping curve,
due laws of variable
proportions.
Costs TC  Total cost (TC)
TVC
 Sum of TFC and TVC.

TFC

O 89
Quantity
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

© Oxford University Press,

2016. All rights reserved.
© Oxford University Press, 2016. All rights
reserved.
Short-Run Cost Functions

Average Variable Cost

AVC = TVC/Q

Marginal Cost
TC/Q = TVC/Q

ed.
 Per Unit Cost Curves in Agro
Industries
• Behavior of estimated AVC, ATC and MC per unit for
in-organic fertilizer, agricultural implements, pump
sets, tractors and harvesters.
• Cost curve follow U shape.
• Inorganic fertilizer industry shows a constant rising
cost curve whereas tractor and harvester industry
showed a V-shaped cost curve indicating steep rise
in cost.
Per unit cost curves in Agro
Industries
 Homework

Dell PCs and Apple iPhones and iPads sold in the

United States Are Anything but American
 Long-Run Cost Functions

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = LTC/Q

© Oxford University Press,

2016. All rights reserved.
© Oxford University Press,
2016. All rights reserved.
Economies of Scale
 Economies of Scale

The advantages of large scale production that result

in lower unit (average) costs (cost per unit)

AC = TC/Q
 Types of Economies of Scale

Internal Economies
External Economies
 Economies of Scale
Capital Land Labour Output TC AC

Scale A 5 3 4 100

Scale B 10 6 8 300

•Assume each unit of capital = £5, Land = £8 and Labour = £2.

•Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of

production facility
 Types of Internal Economies of Scale

Technical Economies
Commercial Economies
Financial Economies
Managerial Economies
Risk Bearing Economies
Division of Labour Economies
Transportation Economies
 Real Life Example of Economies of
Scale
Narayana Hrudayalaya: The Henry Ford of Heart
Surgery
 Charges Rs. 1 Lakh for open heart surgery compared to hospitals in
US that charges 10 to 50 times .

 Also Economies of Scope as “Dr. Shetty built a 1400 bed cancer

hospital and 300 bed eye hospital, which shared the same
laboratories and blood bank at heart institute”.

 Narayana Hrudayalaya reported 7.7 percent profit after taxes or

slightly above 6.9 % average for US hospitals.
 External Economies of Scale

The advantages firms can gain as a result

of the growth of the industry.

Supply of skilled labour

Infrastructure
Training facilities
 Diseconomies of Scale

The disadvantages of large scale production that can

lead to increasing average costs:
Labour Diseconomies
Problems of management
Divorce of ownership and control
Scarcity of resources
 Economies of Scope

• When the production capacity can be utilized for producing more than
one goods, average costs are less as compared to when they are
produced by different firms separately; e.g. Computers and printers;
heavy vehicles and light vehicles.

• Globalization has made such economies even more important to firms

in their production decisions.

• Assume three products at individual costs of C1, C2 and C3, while Ct is

the total cost when the three activities are carried out together, the
Scope Index (S):

(C 1  C 2  C 3  C t )
S=
C1  C 2  C 3 108
 Minimizing Costs Internationally

• Foreign Sourcing of Inputs

• Immigration of Skilled Labor

• Make in India

© Oxford University Press,

2016. All rights reserved.
A Case Study of Dell
 Apple iPhone

The Components of iPhone are entirely Asian

Screen: Japan

Flash Memory: Korea

Assembled : China

Apple contributed the design and software and integrated the

innovations of the others.
Cost-Volume-Profit Analysis

Total Revenue = TR = (P)(Q)

Total Cost = TC = TFC + (AVC)(Q)
Breakeven Volume TR = TC
 Operating Leverage

Operating Leverage = TFC/TVC

Degree of Operating Leverage = DOL

% Q( P  AVC )
DOL  
%Q Q( P  AVC )  TFC

© Oxford University Press,

2016. All rights reserved.
Current News???????
Take–away of today’s lecture
1. Definition of market
2. Features of perfect competition
3. Price and Output determination in short run and
long run
MARKET STRUCTURE AND
PRICING PRACTICES
What is Market?????
It is a place of interaction between

buyers and sellers that facilitates

exchange of goods and services at

mutually agreed upon prices.

Market Structure

Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly
 Perfect Competition
• Many buyers and sellers
• Buyers and sellers are price takers
• Product is homogeneous
• Perfect mobility of resources
• Perfectly Elastic Demand
• Economic agents have perfect knowledge
• AR=MR
• No Advertisement Cost
 Perfect Competition: Price
Determination
QD  625  5 P QS  175  5 P

QD  QS
 Perfect Competition: Long-Run
Equilibrium
Quantity is set by the firm so that short-run:

Price = Marginal Cost = Average Total Cost

At the same quantity, long-run:

Price = Marginal Cost = Average Cost

Economic Profit = 0
 Perfect Competition: Long-Run
Equilibrium
Quantity is set by the firm so that short-run:

Price = Marginal Cost = Average Total Cost

At the same quantity, long-run:

Price = Marginal Cost = Average Cost

Economic Profit = 0