PRODUCTION ANALYSIS

Repo rate hike to put brakes on auto

industry growth: FADA
• Home, auto and other loan EMIs are likely to go up after the Reserve Bank of
India (RBI) hiked its key interest rate by 40 bps in an unexpected move on
Wednesday to tame the rising inflation that has remained stubbornly above target
in the recent months.
• The increase in repo rate - the rate at which RBI lends to commercial banks
- to 4.40 per cent from a record low of 4 per cent is the first since August 2018.
It is also the first instance of the RBI Governor-headed monetary policy
committee (MPC) to hold an unscheduled meeting for raising interest rates.
• The RBI also hiked the cash reserve ratio (CRR) by 50 basis points
(bps) to 4.5 per cent, which will now require banks to park more money
with the central bank and leave them with less to loan to the consumers.
• This move will curb excess liquidity in the system and will make auto
loans expensive.
 Learning Outcomes

 To develop an understanding of the distinction between short

run and long run production functions.
 To build up a critical appraisal of the law of variable
proportions and returns to scale.
 To discuss the significance of Producer’s equilibrium.
 DEFINITION OF PRODUCTION

• Definition
– Production means the process of using the factor of
production to produce goods and services.
– Production is the process of transforming inputs into
outputs.
INPUTS
OUTPUTS
Inputs refers to the
factors of Refers to what we
production get at the end of the
Processing
that a firm use in production process
the that is finished
production process. 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

• A production function is a statement of the functional

relationship between inputs and outputs, where it shows the
maximum output that can be produced with given inputs.

Q = (N,L,K, E)

• Where: Q = Output
N= Land
K = Capital
L = Labour
E = Entrepreneur
 SHORT-RUN AND LONG-RUN PRODUCTION
FUNCTION

• Two Types of Factor Inputs

– Fixed Input
• An input which the quantity does not change according to the
amount of output.
• Example: Machinery, land, buildings, tools, equipment, etc.
– Variable Input
• An input which the quantity changes according to the amount of
output.
• Example: Raw materials, electricity, fuel, transportation,
communication, etc.
• Short-run and Long-run Periods
– Short run period is the time frame, which at least one of the
inputs (factor of production) is fixed and other input can be
varied.
– Long run period is the time frame which all inputs are variable.
 Let’s Do a Poll

Which of the following is not a variable input?

A.Raw materials
B.Electricity
C.Land
D. Transportation
 SHORT-RUN PRODUCTION FUNCTION

• In the short run, we assume that at least one of the

inputs is fixed that is capital.
• Therefore, in the short run the production function
can be written as:
Q = ( K , L)
Where: Q = Output
L = Labour
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
Production or MPL
EL =
Output Elasticity APL
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
 Poll Time

When MP=0, which of the following is true?

A.TP=0
B.TP=+ve
C.TP=Max
D.TP=Min
 Let’s Do a Poll

Causes of Applicability of law of variable proportions

are :
(a) Imperfect substitutes
(b) Under-utilization of fixed factor
(c) Optimum production
(d) All of these
 SHORT-RUN PRODUCTION FUNCTION

Stage I Stage II
Proportion of fixed factors are Called law of diminishing returns



greater than variable factors The most efficient stage of production


Under utilization of fixed factor because the combinations of inputs are fully


Operation involves a waste of resources 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????

1. Why diminishing return operates?

2. Can we postpone the diminishing returns to a

factor?
 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

 Production Function with Two Variable Inputs
Capit Labour MRTS
 All inputs are variable in long run al (Rs. (’00 units)
crore)
and only two inputs are used
 Curves showing such production 40 6 -
function are called isoquants or iso- 28 7 12:1
product curves. 18 8 10:1
 An isoquant is the locus of all
technically efficient combinations of 45
two inputs for producing a given 40

level of output 35
30

Capital (Rs. Crore)

25
 Represented as: 20
15
10
5
0
6 7 8 9 10

Q  f ( L, K ) Labour ('00 units)

The slope of an isoquant is:
A.the marginal product
B.the average product.
C.the marginal cost.
D.the marginal rate of technical substitution.
 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
Capital Capital

C
A

B Q1
B C
Q2

Q0 Q2
O
O Labour Labour
 Special Shapes of Isoquants
Factor 2 Factor 2

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

Linear isoquants Right angled isoquants

•Perfect substitutability •Capital is a perfect complement

between two factors for labor
•Non existence of any
•Gasoline and oil used to 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

Isocost lines represent all combinations of two inputs

that a firm can purchase with the same total cost.

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

r  Cost of Capital ( K )
Iso-cost line is also known as :
a)Factor Price Line
b)Outlay Line
c) Firm’s Budget
 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
 Producer’s Equilibrium
Capital  AB is the isocost line
 Any point below AB is feasible but not
A desirable
C  E is the point of tangency of Q2 with
E isocost line AB
K*
 Corresponds to the highest level of
Q output with given cost function.
Q2 3
D Q1
Q0  Firm would employ L* and K* units of
O labour and capital
L* B Labour
 Q3 is beyond reach of the firm

Maximization of output subject to  Points C and D are also on the same

cost constraint isocost line, but they are on isoquant Q1,
which is lower to Q2. Hence show lower
Necessary condition for equilibrium output.
Slope of isoquant = Slope of
 E is preferred to C and D, which is on
isocost line
the highest feasible isoquant.
 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

 All the factors of production are increased in a given
proportion, output would increase by a greater proportion.
Capital

When labour and capital are doubled

(100 units to 200 units), output
increases from 20 units to 60 units,
which is more than double.

200
The causes of increasing returns
IQ = 60 to scale are specialization,
100%
technical economies,
> 100%
100
IQ =20
managerial economies which
are also known as economies
Labour of scale.
100 200
100%
 SCALE OF PRODUCTION (cont.)

CONSTANT RETURNS TO SCALE

 All the factors of production are increased in a given
proportion, output would increase by same proportion.
Capital

When labour and capital are

doubled (100 units to 200 units),
output increases from 20 units to 40
units.
200
IQ = 40
100%
100%
100
IQ =20

Labour
100 200

100%
 SCALE OF PRODUCTION (cont.)

DECREASING RETURNS TO SCALE

 All the factors of production are increased in a given
proportion, output would increase by a smaller proportion.
Capital

When labour and capital are doubled

(100 units to 200 units), output
increases from 20 units to 30 units,
which is less than double.

200
The causes of decreasing
IQ = 30 returns to scale are internal
100%
and external diseconomies
100
< 100% of scale.
IQ =20

Labour
100 200

100%
 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
© Oxford University Press,
2016. All rights reserved.
 Elasticity of Substitution

 Measures the percentage change in factor proportions due to a

change in marginal rate of technical substitution
d ( K / L)
σ= K/L
d ( MRTS )
MRTS

 σ is effectively a measure of the curvature of an isoquant

 More curved or convex is the isoquant, the lower is σ
 In Leontief (zero substitution) technology, with L shaped isoquants,
there is no substitutability between the inputs
 σ=0
 In perfect substitution or linear production technology, the MRTS
does not change at all along the isoquant.
σ is infinite
Empirical Production Functions

Cobb-Douglas Production Function

Q = AKaLb

Estimated Using Logarithms

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

.
©
 Cobb-Douglas Production Function

 Proposed by Wicksell and tested against statistical evidence by Charles W. Cobb and Paul
H. Douglas in 1928
Q  AK  L
 where α, β are constants. A is the technological parameter, α is the elasticity of
output with respect to capital, and β is the elasticity of output with respect to labour.

 Properties

 Homogeneous of degree (+)

 The returns to scale is immediately revealed by the sum of the two parameters  and 
 Constant Returns to Scale: ( +) = 1
 Increasing Returns to Scale: ( +) > 1

 Decreasing Returns to Scale: ( +) < 1

 Isoquants are negatively sloped and convex to the origin

 MRTSLK is a function of input ratio

 Elasticity of substitution is equal to 1

 Leontief Production Function

 Represents the extreme case of perfect complements

 ‘L’ shaped or right angled isoquants.
 Also known as fixed coefficient production function

L K
Q  min( , )
 
 Production technology always involves inputs labour (L) and capital (K) in fixed
proportions to produce a unit of output and α and в are the fixed coefficients
 A certain amount of each input is required technologically to produce one unit
to output
 Demand for inputs is uniquely determined
 Inputs are required in exact quantities per unit of output
 Any change in MRTS will not lead to any change in the factor proportions: б =
0
 CES Production Function

 Constant Elasticity of Substitution (CES) production function

 Introduced by Arrow, Chenery, Minhas and Solow (also known
as ACMS)
 Q=A[αK -ρ +(1-α)L -ρ ] -r/ρ, where:
 A(>0) is the efficiency parameter which represents the "size" of the
production function
 α is the distribution parameter which will help us explain relative factor
shares (so 0<α<1);
 ρ is the substitution parameter, which will help us derive the elasticity of
substitution and
 r is the scale parameter which determines the degree of homogeneity
 Technical Progress

 Refers to research and development and investments made to

manage technical know how
 Technical change may be
 Embodied or investment specific, where new capital is used in the
production apparatus, which requires investment to take place; or
 Disembodied or investment neutral, where output increases without any
increase in investment but by an innovation through research and
knowledge.
 Types of Technical Progress (Hicks)
 Neutral Technical Progress: changes in the marginal product of labour
(MPL) and capital (MPK) are same
 Labour augmenting Technical Progress: MPL increases faster than the
MPK
 Capital augmenting Technical Progress : MPK increases faster than MPL
 Technical Progress
 Neutral Technical Progress: MRTS is constant and independent of time along the
points on the expansion path; isoquants shift parallel.

 Labour Augmenting Technical Progress: MRTS LK, being the ratio of the marginal
products, decreases.

 Capital Augmenting Technical Progress: MRTS LK,, being the ratio of the marginal
products, increases.

Labour Augmenting Capital Augmenting

Neutral

Capital Q Capital QL Q Capital Q

QK
K
K1
Q Q Q
Q1 QK
QL
O O O
L1 L
Labour Labour Labour
 Euler’s Theorem

 According to marginal productivity theory, every input is

paid the value of its marginal product.
 This means that the entire product will always be handed
out to those who work on it.
 In other words, the sum of the marginal products add up
exactly to the total output.
 There is thus neither a surplus nor a deficit left at the
end.
This proposition can be proved by using Euler’s
Theorem.
It suggests that if a production function involves
constant returns to scale (i.e., the linear
homogeneous production function), the sum of the
marginal products will actually add up to the total
product.