PRODUCTION ANALYSIS

UNIT -IV
• Managerial decision making involves
four types of production decisions:
1.Whether to produce or to shut down
2.How much output to produce
3.What input combination to use
4.What type of technology to use
 Production Meaning
• Production involves transformation of inputs such
as capital, equipment, labor, and land into output -
goods and services
• The utilities which human effort produces are of
following kinds or various kind of production are –
– Form Utility – iron ore to steel, wood into furniture
– Place Utility – things are transferred from useless or less
useful to places where they will actually used
– Time Utility – make things available when they are required.
Bank loan & overdraft
– Personal Utility – services of workers, agents, shopkeepers
etc are included under this head.
 What is production?
• “Production is the process that transforms inputs
into output.”

• “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.”
• In this production process, the manager is
concerned with efficiency in the use of the
inputs
- technical vs. economical efficiency
• 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
Factor of Production
 Factors of Production
• Production involves the use of various
agents or factors of production.
• These are
– Land
– Labour
– Capital
– Enterprise
 Production Function
• A production function is a table or a mathematical
equation showing the maximum amount of output
that can be produced from any specified set of
inputs, given the existing technology

Q f2(x) Improvement of technology

f1(x) f0(x) - f2(x)
f0(x)

Q = output
x = inputs
x
 Production Function continued
Q = f(X1, X2, …, Xk)

where
Q = output
X1, …, Xk = inputs

For our current analysis, let’s reduce the inputs to

two, capital (K) and labor (L):

Q = f(L, K)
 Production Table
Units of K
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed
Same Q can be produced with different combinations of
inputs, e.g. inputs are substitutable in some degree
 All of these outputs are assumed to be
technically efficient

• But which one is economically efficient?

– That is the question facing the Decision

Maker
Managerial uses of production function

- Least-Cost-Factors combination
- Optimum level of output
- Programming technique in production
planning
- Equilibrium level of output
- Returns to scale
• Long Run : shortest period of time required to alter the
amounts of every input.

• Short Run : longest period of time during which at least

one of the inputs used in a production process cannot
be altered.

 Short run: Short run refers to a period of time in which supply

of certain factor inputs is fixed or inelastic.
Long run: Long run refers to a period of time in which the
supply of all the inputs is elastic, but not enough to permit a
change in technology.
 Very long period: Very long period refers to a period of time in
which along with all other factor inputs, the technology of
production can also be changed.
 Short-Run Production
• In the short run some inputs are fixed and
some variable
– e.g. the firm may be able to vary the amount
of labor, but cannot change the amount of
capital
– in the short run we can talk about factor
productivity
 Long-Run Production
• In the long run all inputs become variable
– e.g. the long run is the period in which a
firm can adjust all inputs to changed
conditions
– in the long run we can talk about returns to
scale (compare latter with economies of
scale, which is a cost related concept)
 Short-Run Changes in Production
Factor Productivity
Units of K
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed

How much does the quantity of Q change,

when the quantity of L is increased?
Long-Run Changes in Production
Returns to Scale
Units of K
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed

How much does the quantity of Q change, when

the quantity of both L and K is increased?
 Key terms in production 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.
Concepts
 Marginal
Product
Calculation
 Average
Product
Calculation
 Relationship Between Total, Average,
and Marginal Product: Short-Run
Analysis

• Total Product (TP) = total quantity of output

• Average Product (AP) = total product per total

input

• Marginal Product (MP) = change in quantity

when one additional unit of input used
 The Marginal Product of Labor
• The marginal product of labor is the increase in
output obtained by adding 1 unit of labor but
holding constant the inputs of all other factors

Marginal Product of L:
MPL= Q/L (holding K constant)
= Q/L

Average Product of L:
APL= Q/L (holding K constant)
 Short-Run Analysis of Total,
Average, and Marginal Product
• If MP > AP then AP
is rising
• If MP < AP then AP
is falling
• MP = AP when AP
is maximum
• TP is maximum
when MP = 0
 LAWS OF RETURNS
• The Law of Variable Proportions
– It refers to the behavior of output as the quantity of one input
is increased while the other inputs are held constant.

– It states that as successive units of a variable resource say

labor are added to a fixed resource say land, so beyond some
point the extra or marginal product will decline.

– Till Marshall’s time this law was considered as the three

different laws i.e. Law of Diminishing Return, Law of
Increasing Return and Law of Constant Return.

– But thereafter, these laws were considered as three different

stages of one law which is called as Law of Variable
Proportion.
 ASSUMPTIONS OF THE LAW OF
VARIABLE PROPORTION
• Short Run
• Constant Technology
• Homogeneous Factors

Basic Concepts of the Law

 Total Product (TP)

 Marginal Product (MP)
 Average Product (AP)
 LAW OF VARIABLE PROPORTION

Stage TP
2
Output Stage Stage
1 3

AP
0
MP
No of Workers
Three Stages of Production in Short Run

AP,MP
Stage I Stage II Stage III

APX

MPX X
Fixed input grossly Specialization and
underutilized; teamwork continue to
specialization and result in greater Fixed input capacity
teamwork cause output when is reached;
AP to increase additional X is used; additional X causes
when additional X fixed input being output to fall
is used properly utilized
 Three stages of production

Total Product Marginal Product Average Product

STAGE I
Increases at an Increases and reaches Increases (but slower
increasing rate its maximum than MP)
STAGE II
Increases at a Starts diminishing and Starts diminishing
diminishing rate and becomes equal to zero
becomes maximum
STAGE III
Reaches its maximum, Keeps on declining and Continues to diminish
becomes constant and becomes negative (but must always be
then starts declining greater than zero)
 LAW OF VARIABLE PROPORTION

• Stage 1: Increasing Returns: TP increases at increasing rate &

then increases at decreasing rate after inflexion point, MP
increases & reaches its max then decreases and is greater than
AP, AP reaches to the maximum point.

• Stage 2: Diminishing Returns: TP increases at decreasing rate

and reaches maximum point, MP goes on diminishing, reaches to
zero and is less than AP, AP starts decreasing.

• Stage 3: Negative returns: TP starts decreasing, MP goes to

negative and AP goes on decreasing but greater than MP.
 Law of increasing returns / increasing
returns to a variable factor
• Marginal and average product shows a tendency to rise
at increasing rates with input of additional units of
variable cost. Such behaviour of a product is termed as
law of increasing return. Inversely from cost point of
view, it is termed as law of diminishing cost showing
that marginal cost of production goes on declining.
• According to Marshall: “an increase of labour and
capital leads generally to improved organisation, which
increases the efficiency of the work of the labour and
capital.”
• According to Benham: “as the production of one factor
in the combination of factors is increased up to a point,
the marginal product of the factor will increase.”
 Law of increasing returns / increasing
returns to a variable factor

Causes for the operation of the law :

1. Indivisibility of factors – eg., teacher
2. Increase in efficiency
3. Fixed factors and fixed costs – eg., rent, wages
4. Division of labour / specialization
5. Economies
6. Before the point of optimum combination
 Law of constant returns / constant
returns to a variable factor
• According to Marshall: “the stage of constant returns
comes at that point, where the effects of increasing
returns and diminishing returns balance each other.”
Under constant returns, MP and AP curves become one
and the same and it becomes constant, i.e., parallel to
the x-axis.
Why does the law operate?
1. Optimum utilisation of variable factor
2. Ideal factor ratio
3. Most ideal utilisation of variable factor
 Law of diminishing returns / diminishing
returns to a variable factor

• According to Marshall: “An increase in capital and labour

applied in the cultivation of land causes in general less
than proportionate increase in the amount of produce
raised, unless it happens to coincide with the improvement
in the art of agriculture.”
Keeping the fixed factors constant, when MP diminishes with
the increase in the quantities of a variable factor, it is
called law of diminishing returns. From cost point of view,
it is law of increasing cost, because MC increases with the
increase in variable factor.
• Scope of the Law.
 Law of diminishing returns / diminishing
returns to a variable factor
Causes for the operation of the law:
1. Certain factors become fixed.
2. Certain factors become scarce.
3. Substitution of all the factors is not available, and
4. Maximum optimum level of production has already
been achieved.
 LAW OF VARIABLE PROPORTION
No. of Workers Total Product Marginal Average
Product Product
0 0 - -
1 10 10 10
Increasing
2 25 15 Marginal 12.50
Return
3 45 20 15
4 60 15 15
Diminishing
5 70 10 Marginal 14
Return
6 75 5 12.5
7 75 0 Negative
10.71
8 70 -5 Marginal 8.75
Return
 How to Determine the Optimal Input
Usage
• We can find the answer to this from the concept
of derived demand

• The firm must know how many units of output

it could sell, the price of the product, and the
monetary costs of employing various amounts
of the input L

• Let us for now assume that the firm is operating

in a perfectly competitive market for its output
and its input
 Note: P = Product Price = 2
Example W = Cost per unit of labor = 10000
TRP = TP x P, MRP = MP x P
TLC = X x W
MLC = TLC / X

Table 7.6 Combining Marginal Revenue Product (MRP) with Marginal Labor Cost (MLC)
Total Marginal Total Marginal
Labor Total Average Marginal Revenue Revenue Labor Labor
Unit Product Product Product Product Product Cost Cost
(X) (Q or TP) (AP) (MP) (TRP) (MRP) (TLC) (MLC) TRP-TLC MRP-MLC
0 0 0 0 0 0 0
1 10000 10000 10000 20000 20000 10000 10000 10000 10000
2 25000 12500 15000 50000 30000 20000 10000 30000 20000
3 45000 15000 20000 90000 40000 30000 10000 60000 30000
4 60000 15000 15000 120000 30000 40000 10000 80000 20000
5 70000 14000 10000 140000 20000 50000 10000 90000 10000
6 75000 12500 5000 150000 10000 60000 10000 90000 0
7 78000 11143 3000 156000 6000 70000 10000 86000 -4000
8 80000 10000 2000 160000 4000 80000 10000 80000 -6000
 Optimal Decision Rule:
A profit maximizing firm operating in
perfectly competitive output and input
markets will be using optimal amount of an
input at the point at which the monetary
value of the input’s marginal product is equal
to the additional cost of using that input (L)

- in other words, when MRP = MLC

Returns
to

Scale
Production Function With Two Variable
Inputs

• Long run analysis : The firm uses only two inputs

and both of them are variable i.e. both labor &
capital are variable factors.
• Graphical method of presenting production
function in long run is ‘isoquant curve’
Isoquant : An Isoquant is a curve representing
various combinations of two variable inputs that
produce same amount of output.
- This is also known as Iso-Product curve, Equal-
Product curve or Production Indifference curve.
 Assumptions of Isoquants
• Producers uses two inputs, labor (L) and
capital (K), to produce a commodity X.
• Both L & K can be substituted for one
another at diminishing rate.
• Technology of production is constant.
• Production function is continuous, i.e. labor
& capital are divisible and substitutable.
 Properties of Isoquants

• It is downward sloping from the left to the

right (negatively inclined)
• It is convex to origin (Marginal Rate of
Technical Substitution)
• Higher isoquant represents larger output
• No two isoquants intersect
 The Marginal Rate of Technical
Substitution
• MRTS is the rate at which one input can be
exchanged for another without altering
output.

• MRTS is the absolute value of the slope of

the isoquant : |ΔK/ΔL|
 The Marginal Rate of Technical
Substitution
• Holding output constant, the less we have
of one input, the more we must add of the
other input to compensate from a one-unit
reduction in the first input.

• The MRTS at A is the ratio of the MPLA to

MPKA : MPLA = ΔK
MPKA ΔL
 The Marginal Rate
of Technical Substitution
 The Marginal Rate of Technical
Substitution
• Similar to indifference curves, isoquants
may tell us how firms are willing to
substitute one input for another.

• At the extreme cases, inputs may be perfect

substitutes or perfect complements.
Isoquant Map: A whole array of isoquants
represented on a graph is called an isoquant
map.
Economic Regions of Production – The ridge
lines : The ranges over which the marginal
products of the inputs are diminishing but
positive.
A ridge line is the locus of points of isoquants
where MP of input is zero.
 ISOQUANTS OR EQUAL PRODUCT
CURVES
• It means equal quantity produced. It shows various
combinations of two inputs say Labor and Capital
giving the same level of output.

Combinatio Factor X Factor Y Total DMRTS xy

ns Output
A 1 12 100 units
B 2 8 100 units 4:1
C 3 5 100 units 3:1
D 4 3 100 units 2:1
E 5 2 100 units 1:1
 ISOCOST CURVES
• Suppose a firm has Rs.400 to spend on the combination of two
factors for producing a level of output. So it will have the
following Isocost curve.
A
10
B
8
C
Factor Y 6
Rs.40 per unit
D
4
E
2
F
0
1 2 3 4 5
Factor X
Rs.80 per unit
 Types of Isoquants
• Linear isoquants – Perfect substitutability
between factors of production
• Right-angle Isoquants – Strict
complimentarity / zero substitutability
between input factors (fixed factor – proportion
isoquants)
• Convex isoquants – Continuous
substitutability over a certain range between
the input factors
Isoquant Maps for Perfect Substitutes and
Perfect Complements
 Laws of Returns to Scale
• The laws of Returns to Scale study the behavior of
production when all the productive factors or inputs are
increased or decreased simultaneously in the same ratio.
• The percentage increase in output when all inputs vary in
the same proportion is known as returns to scale.

 Three Situations of Returns To Scale

- Increasing Returns to Scale – Output increases by a
greater proportion than the increase in input.
- Constant Returns to Scale – Output increases in same
proportion as increase in inputs.
- Decreasing Returns to Scale – Output increases in a lesser
proportion than the increase in input.
 RETURNS TO SCALE
Sl. Scale of Production Total Marginal Returns
No. Returns
1 1 Worker+3 Acres of land 2 2
2 2 workers+6 Acres of land 5 3
Increasing
3 3 +9 9 4 Returns
4 4 +12 14 5
5 5 +15 19 5 Constant
6 6 +18 24 5 Returns
7 7 +21 28 4
8 8 +24 31 3 Decrasing
Returns
9 9 +27 33 2
 RETURNS TO SCALE

4 Stage
2
3 Stage Stage
1 3
MP
2

0 1 2 3 4 5 6 7 8 9 10
Scale
 Increasing returns to scale (IRS)
• when all inputs are
doubled, output more
than doubles
f(2L, 2K) > 2f(L, K)
• increasing the size of a
cubic storage tank:
outside surface (two-
dimensional) rises less
than in proportion to the
inside capacity (three-
dimensional)
 Constant returns to scale (CRS)
• when all inputs are
doubled, output
doubles
f(2L, 2K) = 2f(L, K)
• potato-salad
production function
is CRS
 Decreasing returns to scale
(DRS)
• when all inputs are doubled,
output rises less than
proportionally
f(2L, 2K) < 2f(L, K)
• decreasing returns to scale
because
– difficulty organizing,
coordinating, and integrating
activities rises with firm size
– large teams of workers may
not function as well as small
teams
Economies of Large Scale
Production
 Internal Economies of scale
 Labour Economies
 Technical Economies
- Superior Technique - Increased Dimension
- Linked Processes - By- products
 Managerial Economies
 Delegation of details
 Functional specialisation
 Marketing or Commercial Economies
 Financial Economies
 Transport & Storage Economies
 Overhead Economies
 Risk bearing Economies
- Diversification of output - Diversification of market
- Diversification of source of supply – Diversification of
process of manufacturing
 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 Information
Economies of Vertical Disintegration
 Internal Diseconomies of scale
 Difficulties of management
 Difficulties of Co-Ordination
 Difficulties of Decision making
 Increased risk
 Labour Diseconomies
 Scarcity of Factor Supplies
 Financial difficulties
 Market diseconomies
 External Diseconomies of scale
• Increase in factor (labor, capital, land)
prices resulting from increase in their
demand.
• Prices of raw materials, transportation &
communication cost may go up.
• There would be more congestion and
pollution. Price index in general may
increase and cost of living index may go up.
Part of an Isoquant Map for the
Production Function
Returns to Scale on an Isoquant Map

• The degree of returns to scale may vary for

a specific production function, depending
on the level of output.
 Return to Scale on an Isoquant Map

Units of Units of % change in Total Increase in Return to

Labor Capital Labor & Capital Product Total product Scale
1 3 - 30 -
2 6 100 90 60 Increasing

3 9 50 180 90
4 12 33.33 240 60
5 15 25 300 60 Constant

6 18 20 360 60
7 21 16.66 400 40
8 24 14.29 420 20 Decreasin
g
Returns to Scale Shown on the Isoquant
Map
 The Distinction between
Diminishing Returns and Decreasing
Returns to Scale
• Diminishing returns to scale is a short run
concept that refers to the case in which one
input varies while all others are held fixed.

• Decreasing returns to scale is a long run

concept that refers to the case in which all
inputs are varied by the same proportion.
 Law of returns to scale
Causes of the operation of the law:

When internal and external economies exceed the

diseconomies, the stage of increasing returns to
scale operates;
when economies and diseconomies are equal to each
other, it becomes the stage of constant returns to
scale; and
when diseconomies exceed the economies, law of
decreasing returns to scale is said to operate.
 Differences between returns to a variable factor
and returns to scale
1. Period
2. Change in factors
3. Change in factor ratio
4. Change in the scale of production
Economies of scale
• Internal economies
1. Technical managerial
2. Labour
3. Marketing
4. Financial
• External economies
1. Centralisation of industries
2. Information
3. Decentralisation