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PRODUCTION

ANALYSIS
PRODUCTION ANALYSIS

The Production Process


Production is a process in which economic resources or inputs (composed of
natural resources like labour, land and capital equipment) are combined by
entrepreneurs to create economic goods and services (outputs or products).

P r o d u c t io n M a n a g e m e n t

L a b o u r FO RM AT P o l lu t io n O
I NS
U

IO
N
A
TR

N
P N a t u r a l
U R e s o u r c e s , L a n d P
T U
S C a p it a l, E q u ip m e n t G o o d s & S Te r v i c e s
M a c h i n e s PRO C ESS S

C O N T R O L S
PRODUCTION ANALYSIS

The Production Function

'A production function defines the relationship between inputs and the
maximum amount that can be produced within a given period of time with a
given level of technology'.
Two special features of a production function are:
a. Labour and capital are both inevitable inputs to produce any quantity of
a good, and
b. Labour and capital are substitutes to each other in production.
PRODUCTION ANALYSIS
Short Run and Long Run Production Function

Labour(L) Capital (K)

0 1 2 3 4 5 6 7 8 9 10

0 0 0 0 0 0 0 0 0 0 0 0
1 0 5 15 35 47 55 62 61 59 56 52
2 0 12 31 49 58 66 72 77 72 74 71
3 0 35 48 59 68 75 82 87 91 89 87
4 0 48 59 68 72 84 91 96 99 102 101
5 0 56 68 76 85 92 99 104 108 111 113
6 0 55 72 83 91 99 107 112 117 120 122
7 0 53 73 89 97 104 111 117 122 125 127
8 0 50 72 91 100 107 114 120 124 127 129
9 0 46 70 90 102 109 116 121 125 128 130
10 0 40 67 89 103 110 117 122 126 129 131

Long Run Production Function

Both labour and capital are varying.


PRODUCTION ANALYSIS

Capital is constant

Labour (L) 0 1 2 3 4 5 6 7 8 9 10

Output (Q) 0 15 31 48 59 68 72 73 72 70 67

Short Run Production Function


PRODUCTION ANALYSIS

The Three Stages of Production


Total Physical Marginal Physical Average Physical
Product (Total Product (Marginal Product (Average
Product) Product) Product)

Stage I
Increases at an increasing Increases and reaches its Increases (but slower than
rate maximum MPP)
Stage II
Increases at a diminishing Starts diminishing and Starts diminishing
rate and becomes maximum becomes equal to zero

Stage III
Reaches its maximum, Keeps on declining and continues to diminish but
becomes constant and then becomes negative must always be greater than
starts declining zero
Production with one variable
input/law of diminishing marginal
returns
One input increasing with other input fixed, total
output increases at an increasing rate, then
increases at a decreasing rate, then reaches
maximum and then falls and ultimately reaches
zero.
Thus short run production function shows the
maximum output a firm can produce when only
one input can be varied, other inputs remain
fixed.
Total product, average product, marginal product
and their shapes. Three regions of production
and the efficient zone of production.
Total PhysicalMarginal Average
PRODUCTION ANALYSIS
Physical Physical
Product Product Product

Stage I
Increases at an Increases and Increases (but
increasing rate reaches its slower than
maximum MPP)

Stage II
Increases at a Starts Starts
Fixed inputs grossly Specialisation Fixed inputs diminishing rate diminishing and diminishing
under utilised, and teamwork capacity is reached, and becomes becomes equal
specialisation and team continue and additional X causes maximum to zero
work cause APP to result in greater output to fall
increase when additional output when
X is used additional X is
used, fixed Stage III
input is being
Reaches its Keeps on continues to
properly utilised.
maximum, declining and diminish but
becomes becomes must always be
constant and negative greater than
then starts zero
declining
PRODUCTION ANALYSIS

The Production Function with Two Variable Inputs


A firm may increase its output by using more of two variable inputs that are
substitutes for each other, e.g., labour and capital.

The technical possibilities of producing an output level by various


combinations of the two factors can be graphically represented in terms of an
isoquant (also called iso-product curve, equal-product curve or production
indifference curve).
PRODUCTION ANALYSIS

Isoquants

Isoquants are a geometric representation of the production function. The


same level of output can be produced by various combinations of factor
inputs. Assuming continuous variation in the possible combination of labour
and capital, we can draw a curve by plotting all these alternative
combinations for a given level of output. This curve which is the locus of all
possible combination is called the 'isoquant'. Isoquant shows the different
combinations of capital and labour which can be used by the producer for
producing a certain level of output. Shape of an isoquant is as follows:
PRODUCTION ANALYSIS

Characteristics of Isoquants
Isoquants show the following characteristics:
a. They slope downward to the right/ they are
negatively sloped.
b. It is convex to origin.
c. It is smooth and continuous.
d. Two isoquants do not intersect
e. Isoquants further from origin shows higher
level of output.
PRODUCTION ANALYSIS

Marginal Rate of Technical Substitution


The marginal rate of technical substitution (MRTS) is numerically equal to the
negative of the slope of an isoquant at any one point and is geometrically
given by the slope of the tangent to the isoquant at that point. It is the amount
of one input sacrificed for using an additional unit of the other input.

MRTS (L,K): amount of capital sacrificed for an additional unit of labour


employed. MRTS(L,K)= K/ L

MRTS diminishes as one substitutes labour for capital


Isocost line
It shows various combinations of two factors of production that a firm
can employ, given the total cost and prices of inputs.
C=wL+rK
C: total cost (funds), w: price of labour (wage), L: amount of labour
employed, r: price of capital (interest), K: amount of capital employed
wL: labour cost, rK: capital cost
Slope of isocost line: w/r (ratio of input prices)
K

L
PRODUCTION ANALYSIS

Constrained Optimisation
There are two alternative ways of determining optimal input combinations, the
prices of which are given as (a) a problem of maximising output subject to
cost constraint or (b) a problem of minimising cost subject to output constraint
(i.e., minimising the total cost of producing a specified level of output).
PRODUCTION ANALYSIS

Producer’s equilibrium

Optimum Factor Combination


(a) Maximisation of output subject to a given cost constraint
PRODUCTION ANALYSIS

Returns to Scale: if both the inputs change in same proportion ,in what
Proportion the output changes.

Returns to scale are classified as follows:


a. Increasing Returns to Scale (IRS): If output increase more than
proportionate to the increase in all inputs.
b. Constant Returns to Scale (CRS): If all inputs are increased by some
proportion, output will also increase by the same proportion.
c. Decreasing Returns to Scale (DRS): If increase in output is less than
proportionate to the increase in all inputs.
PRODUCTION ANALYSIS

The Importance of Production Functions in Managerial Decision


Making
i. Careful Planning Can Help a Firm to Use its Resources in a Rational
Manner.

ii. Managers must understand the marginal benefits and cost of each
decision involving the allocation of scarce resources.
Expansion path

Expansion path is the line formed by


joining the tangency points between
various isocosts and the
corresponding highest attainable
isoquants.

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