Final Material

MANAGERIAL ECONOMICS SECTION 1 CHAPTER 4

PRODUCTION ANALYSIS         

WEIGHTAGE IN FINAL EXAMS 5 TO 10 MARKS

Ÿ

Production:

Production is an activity that creates utility or value. It includes any process that transforms inputs into output since production refers creation of utility with exchange value; it may take any of the forms like form utility, place, time & service utility. E.g. 1) Furniture made of wood

Changing the shape.

2) Food grains are shifted from Farm to the city market by grain merchants. 3) Storing and preserving certain goods over a period of time. Doctor, lawyers, Teachers, Bankers etc...Service utility.

x According to Prof. Nicholson:“Production is the creation or additional of those economic utility which in general are the result of labour possesses exchange value and are appropriate.”

    

¾ Production function: Production function expresses a relationship between output & input under condition of given technology. Thus, given the technical conditions of production, the output of a particular type of goods depends on the quantity of 2 or more inputs. Q = F [Labour, Land, Capital, Mgt, Technology] Here Q is quality of output of output which can be produced by combining inputs land, labour, capital; mgt. F is function relationship between output and input. Thus, above equation explain that the quantity of output produced depends on the quantities of input produced depends on the quantities of inputs which are used for producing the commodity. There are two types of production function. 1. Short run. 2. Long run.

Q – What is production? Explain factors of Production.

Introduction: Production consists of producing, storing and distributing goods and services supply of a product refers to its quantity which the seller is ready to offer at a given price once demand for the product known it’s quantity supplied depends on the factor like production conditions of the sellers which include technology input supply managerial efficiency etc...

Meaning: For a lay man, production means creation of new goods and services, as if from now here. But in economics production generally means transformation of inputs into output of goods and services. This process of transformation can be any one of the following 3 kinds. i. Change in form

e.g. milk into ice-cream

ii. Change in Place

e.g. transportation

iii. Change in time

e.g. storage.

Factors of production: Whenever a commodity or a service is to be produced, it requires input, also called factors of production. In a broad sense inputs are classified into Land, Labour, Capital, Organisation or management and technology the inputs or factors of production that they yield optimum output at minimum cost in the given situation. We shell discuss each factor of production briefly as below:

Land: It is one of the basic factors of production because without land no production can take place. Land is a free gift of nature its supply in absolute terms in perfectly inelastic, it is immobile, it differs in quality in terms of fertility and location both and finally the properties of land are indestructible.

Labour: Like land, Labour also is a basic factor of production because like land, without labour also nothing can be produced. It includes mental and physical labour both in other words any one offers his services in return for a reward, called wages is to be included in the category of labour.

Capital: Capital is a man-made factor of production and is defined as the produced goods of production. It includes not only its financial component but also plants, machinery, tools, raw-materials etc... With the help of which capital goods can be purchased and more economic wealth is created. In other words, when prudently used, it multiplies

itself. It is a man-made input in the sense that it is generated form savings which is a residue of income after consumption expenditure is incurred by the community, Symbolically y – c= s, where y is the aggregate saving, provided that y > c , when savings are invested in take the form of capital. Capital is a complementary factor of production. It is perishable and mobile capital in each group identical

Organisation or management: Like capital, organisation or management is also a complementary factor of production. Production is a process in which various factors of production are mobilised and brought together. This activity is generally shouldered by an entrepreneur who takes the risks and bears the uncertainties associated with production.

Technology: This is the most modern form of factors of production it is prevalent these days. Technology implies the use of the mechanical arts and applied sciences in the process of production. The type of technology used in production determines the rate of output as well as the quality of the products. Technology depends upon research and development as well as on innovations.

Q– Law of returns? There are 3 laws of returns. 1. The law of diminishing returns. 2. The law of constant returns. 3. The law of increasing returns. oWhen increase in output is equal to the proportionate increase in factors of production we have constant returns to scale. oWhen the increase in output is more than the proportionate increase in the factors of production, we have increasing returns to scale. oWhen the increase in output is less than proportionate increase in the factor of production we have diminishing or decreasing returns to scale. x Increasing returns is known as decreasing cast because per unit cost decreases. x Constant returns is known a constant cost (if you more forward with production then you will get decreasing returns. It suggestions to stop your production) x Decreasing returns is known an increasing cost because the per unit cost increases.

Law of diminishing returns Description: The law of diminishing returns is one of the most fundamental law of economics and it is nothing but a generalization drawn from the experience of farmers. A Scottish farmer is said to have been the first to state this law. All the farmers know that they can not raise on unlimited amount of produce from 1 acre of land as he cultivates more intensively by applying more and more units of labour and capital. After a certain stage the produce does not increase in the same proportion. In other words the returns from land after a certain point do not increase in the same proportions as compared to the expenditure incurred i.e. the returns increase but at a diminishing rate. Marshall has stated this law as follow “An increase in capital and labour applied in the cultivation of land courses in general less than proportionate increase in the amount of produce raised, unless it happens to co-inside with an improvement in the art of agriculture. Explanation of the law:The law makes clear the following 2 points: 1) The phase “in general” is important. It emphasises the point that in ordinary course of time this tendency should operate but there are certain cases where the successive units of capital and labour may give proportionate increasing returns. But however the law would not be wrong. The law states that beyond a cultivation of land has been reached, every further increase in the amount of labour and capital applied to

its produces less than proportionate returns. In other words, it is only after a certain stage that the successive units of labour and capital give diminishing returns. The law refers to the marginal produce and not to the total produce i.e. it is not that the total returns from land diminish but that the additional returns as a result of the additional expenditure is less than proportionate to it. 2) The phase “unless it happens to co-inside with an improvement in the area of agriculture is also important” this means that if improvements are introduced in the method of cultivation the tendency to diminishing returns will not operate. But if all the things remain the same and no improvements are introduced in the method of cultivation. The law will hold good. Units of capital & labour

Total production

Average production

1

10

10

2

22

11

3

36

12

4

50

12.5

5

61

12.2

6

68

11.3

Marginal production

10 increasing 12 14 constant 14 11 diminishing 7

Let us suppose worth. 10 acres it production of his plot more units of labour land.

that a farmer has a plot of land is interested in increasing the of land and he applies more and and capital on the same pot of

In the diagram along OX axis we measure the units of labour and capital and along the OY axis we measure the marginal output the production first increases at an increasing rate which is represented by the line BC and ultimately the total production increases at a diminishing rate which is represented by the line CD. The law of diminishing returns operates after point C. It should however be notes that the law of diminishing returns do not state that the total produce will diminish, the total produce increases but after a certain point it increases at a diminishing rate.

¾ Assumptions of the law: The law of diminishing returns is based on certain assumptions. They are as follows: 1. The first assumption is that of the factors of production is fixed or constant we have taken a plot of acres of land and assume that the farmer applies the successive unit of labour and capital on this plot of land. 2. The second assumption is that all the different units of a variable factor i.e. labour and capital are homogenous. 3. The third assumption is that there is no improvement in the art or methods of cultivation production techniques remain the same. If however improved methods improved seeds and fertilizers are used the law may not operate. 4. The law assumes that it should be possible to change the combination of the factors of production by using a little less or more of one of the factors. The law will not apply to cases where the combination of the factors is fixed.

Law of constant returns It is a case in which output increases (or decreases) exactly in the same proportion in which input or factors of production are increased (or decreased). In such a situation the casts also do not change and that is why this law is known as the law of constant returns. This law represents the phase of transition between the tow laws, the law of diminishing return and the law of increasing returns. In other words, the law of constant returns establishes a relationship that exists between the other tow laws. Prof. Stigler has defined the law of constant returns as “when all the productive services are increased in a given proportion the product is increased in the same production”. Thus this law does not make any distinction between fixed factor and variable factor. The important point of take increased (or decreased) in the same proportion so as to lead an equivalent result in output e.g. if all the input are doubled the output would also be doubled. If all the inputs are halved in units, output would also be halved. This law is based on two main assumptions. 1) It is possible for the firm to increase or decrease input exactly in the same proportion. 2) Factors of production or inputs employed by the firm are perfectly. Economist like Joan Robinson, Kaldor, K.f.Knight, and lerner subscribe to the view that it is possible to change inputs in the same proportion so that constant returns is possible although Prof. Chamberlin does not agree with their view. According to him there is greater possibility specialisation

and technological up gradation in the firm. Never the less, the law of constant returns reflects an optimum combination of inputs in a firm at a given moment of time. If the firm increases its output beyond that point the law of diminishing returns would operate.

Law of increasing returns Increasing return stipulate that output increases in a greater proportion than the increase in inputs. It is a case where output increases in a larger proportion than the proportion in which costs increase assuming that the supply of input or productive factors is elastic, an expansion of a manufacturing firm. Up to a point, is accompanied by a more than proportionate increase in returns what is stated by this law is that total output may increase at an increasing rate at every new stage of production which implies that when the law operates the marginal return goes an increasing. In the words of Prof. Marshall “An increase of labour and capital leads generally to improved organisation, which increases the efficiency of the work of labour and capital therefore, in those industries which are not engaged in raising raw produce, an increase of labour and capital generally gives an increased return more than in proportion” Prof. Chapman has stated the law thus, “the expansion of an industry, provided that there is no dearth of suitable agents of production, tends to be accompanied, other things being equal by increasing returns”.

Conclusions: 1) The cause of increasing returns is to be traced to expansion of the firm leading to an improvement in its organisational set up. Increasing returns thus are associated with the change in the scale of production. 2) The law is conditional in the sense that it will operate only if there is no dearth of suitable agents of production. This means that the law operate in all spheres of production activity wherever this condition is fulfilled. 3) Unlike the law of diminishing returns, this law is not certain to operate. It may or may not. 4) The law will operate only when the factors of production are combined in appropriate proportions with each other.

Illustration: Let us suppose that a firm wants to maximise its profit by producing more and more units of its product by using more and more units of capital and labour. Given this situation the following table shows the tendency of increasing return in the firm– Units of capital & labour

1 2 3 4 5

Total output (in Average output unite) (in unit)

500 1200 2100 3200 4700

500 600 700 800 900

Marginal output (in units)

500 700 900 1100 1500

In the diagram, we have measured units of capital and labour on the horizontal axis OX and marginal output on the vertical axis OY. The diagram is based on the table given above. The upward moving MP curve shows that with every successive unit of capital and labour there is more than proportionate increase in the output. The MP curve itself depicts the movement of the trend called increasing returns.

Law of variable proportions The law of variable proportions is based on certain assumption. 1. We assume that one input or one factor of production is fixed, and others are variable. 2. All the units of variable inputs are identical or homogenous in respect of their productivity. 3. The technique of production remains the same. 4. Only physical inputs and outputs are considered and not the economic profitability. 5. The behaviour of an entrepreneur is rational. 6. The proportions are cariable i.e. there are no fixed proportions in which output are combined

The law of variable proportions presents relationship between the change in variable factors and the change in output. The fixed factor i.e. land remains constant. But the variable factor i.e. labour and capital changes, and there is a change in the output. Initially the output rises more than proportionately than it rises at a constant rate. But after a point it rises less than proportionately. These 3 phases are explained as the law of increasing returns, law of constant returns and law of diminishing returns. When the units of one factor are changed, keeping all other inputs constant the proportion between the fixed inputs are variable inputs undergoing a change. The effect on output clue to variations in factor proportions is called the law of variable proportions. The law states “if one input is held

constant and if another facto is varied, the total output will increased at an increasing rate in the first instance and then at a diminishing rate. The law can be explained with reference to 3 stages of proportion:

Stage-1:In the first the total output average output and up to a certain extent marginal output are increasing in this stage the marginal output increases at an increasing rate initially, reaches maximum and then starts increasing at decreasing rate. The average output reaches its maximum point at the end of the first stage. There fore, initially there are increasing returns and then there are diminishing returns point K shows maximum average output.

Stage-2:In the second stage both the average output and marginal output are falling when the number of units of labour and capital reaches point N, the marginal output is zero. At this point total output is maximum which is represented by point P in the diagram marginal output is falling falter than the average output the point P shows maximum output.

Stage-3:In the third stage, the marginal output is less than zero and is still falling from this point onwards the total output is

also falling. In the third stage all the three. .i.e. marginal output, average output and total output are falling.

Conclusion: It may be concluded that economic efficiency rises during stage more and more output is attained per unit of land which is the fixed factor, and labour and capital which are the variable factors. Therefore the firm will cross the first stag and week in the second stage. The three i.e. marginal average and total output are declining.

Q/- Explain ISO-quant or equal product curve and its characteristics with relevant diagram? Introduction:Production of any good or commodity depends on the combination and changes in proportion of factors of production when all the factors are increased simultaneously. Then there is increases in the output Prof. Cobb and Douglas assumed that the production function has only 2 factors i.e. capital & labour.

Meaning: According to Prof. Kerrptead equal product curve represents all possible combinations of 2 factors that will give equal level of output per unit of time. In the word of Cobb and Douglas, an equal product curve is a curve along which the maximum rate of production remains constant.

Illustration:

No. Of combinatio n

Factor ‘X’ Capital

Factor ‘Y’ Labour

Total output

Mt Rs. (labour & capital)

1 2 3 4

1 2+1 3+1 4+1

10 7-3 5-2 4-1

100 100 100 100

--1:3 1:2 1:1

From the table that is above, it is seen that, the unit of factor ‘X’ i.e. capital is increasing at the cost of factor ‘Y’ i.e. labour. The marginal rate of substitution is decreasing as more units of labour are substituted for capital

The ISO quant is downward sloping form left to right. It is a line or a curve joining all points representing different combinations of inputs producing equal level of output.

Characteristics of ISO-quant: 1. Equal product curve stop downwards form left to right:-

The ISO-quant has a negative slope because it indicates the decrease in marginal rate of substitution. If the slope of the curve is moving upwards to the right it indicates that as both the factors of production are increasing, the output also increases. If the curve is a horizontal straight line then the units of capital are increasing with constant units of labour resulting into more production. There fare, this curve slopes downward from left to right. 2. Equal product curve is convex to the origin: This implies that the marginal significance of one factor in terms of another diminishes along an equal product curve the marginal significance of ‘X’ i.e. capital in terms of ‘Y’ i.e. labour, is the quantity of labour which can be given off for one more unit of capital. It means that the marginal significance of ‘X’ in terms of ‘Y’ diminishes along an equal product curve. There fore it is convex to the origin.

3. Equal product curve lying to the right represents a larger output: An equal product curve lying to the right indicating a larger output means that they are parallel to each other

In the diagram point P indicates a point on IQ. Whereas point p1 is on TQ2, P1 indicates more units of capital and same units of labour. Therefore, due to increase in capital with labour gives a higher amount of output. 4. Equal product curve never intersects cut each other:The 2 ISO-quant can never intersect each other. For E.g. If they intersect at point P it can be shown in the following diagram:

In this diagram, two ISO-quant curves are intersecting at point P which gives equal output on both the curves, IQ1 and IQ2. If we take IQ1 the output at point P and point A are equal. In the same way on IQ2 the output is equal on point P and B. In both the curves the combinations of capital and labour are equal at point P, but are not equal at point A and B. A and B are on different ISO-quant giving different production. Therefore, we can say that the 2 ISO-quant can never intersect or cut each other. 5. Units of output shown on equal product curve is arbitrary (imaginary) :Various units of output such as 10, 20, 30 etc. On equal product curve map are purely imaginary or arbitrary. 6. In between two ISO-quants, there can be a number of ISO-quants: Different ISO-quants show different levels of output which the combination of two factors can

yield. Therefore, there are many ISO-quants which can be drawn in between each other. 7. No ISO-quant can touch either of the axis: If an ISO-quant touches either X-axis or Y-axis, it shows that the product is being produced with the keep of either labour or capital alone. This is not possible.

8. ISO-quant and optimum factor combination: The equal product curves show different combination of two factors of production which will give the same output the firm has to pay the prices as rewards to the factors of production. The cost line indicates the budget line of the firm. Different combinations of payment paid to the factors of production will give the total cost of production. A rational entrepreneur would choose only that combination which cost him the least in a given situation. Ultimately the firm will look to the cost curve and the production curve on the basis of the

equilibrium i.e. the tendency between the ISOquant and the ISO cost line.

Situation. Ultimately the firm will look to the cost curve and the production curve on the basis of the equilibrium i.e. the tendency between the ISOquant and the ISO cost line.

In the diagram represents least cost input combination or optimum factor combination. The firm is in equilibrium at point & where ISO-quant IQ2 is tangent to ISO cost line PP1. 9. The equal product curve help to determine the boundary lines for the economic region of production: The equal product curve IQ helps the firm to decide the boundary line for the economic region

of production. An equal product curve is convex to the origin with a positive slope at both the ends. This can be show by the following diagram:

As shown in the diagram there are 3 ISO quants IQ1, IQ2, IQ3 points a and d are on IQ1 similarly, point B and E and points C and F are on IQ2 and IQ3 respectively. By joining the points a, b, c we get OQ curve. In the same way we obtain the curve OR by joining the points d, e and f. These lines/curves are known as ridge line or boundary lines. They represent the boundary for the economic region of production. In other words only that portion of the equal product curve which lies between the ridge lines, the production is carried out.

Q/- Expansion Path? An expansion path of firm indicates the best way various inputs can be obtained at a given time in which inputs can be freely varied, subject to the condition that input prices and technology are constant. It shows the locus of the least cost input combinations for obtaining different levels of output

Expansion path is an expansion of a situation in which the resources available with a firm expands which means that it

can hire more and more units of the inputs so as to attain higher and higher ISO-quants. In the diagram, units of capital are measured on the vertical axis OY. IQ1 to IQ6 are the different levels of ISOquants while the lines from K1L1 to K6L6 are the different ISOquants and ISO-cost lines at different levels of output indicating the availability of resources and efficiency of the firm. By joining the different points of equilibria. We get the expansion path of the firm when its recourses go on expanding so that at each new stage it hires more units of capital and labour both.

Q:- Marginal rate of technical substitution (M R T S) This is one of the important concepts associated with production function MRTS is the rate at which two inputs are substituted for rate of substitution between such inputs which are imperfect substitutes and therefore the unit of one input can be replaced by units of the other. As stated earlier, capital and labour are imperfect substitutes and there fore when a firm wants to reduce the cost of production output remaining the same, it would substitute a costlier input by a cheaper input MRTS will indicate the number of units of input K (capital) that can be replaced by one unit of L (labour). Quantity of output remaining unchanged. It is an intermediate position in which the inputs are neither perfect complements nor are they perfect substitutes.

Illustration: The following table and the subsequent diagram indicate the MRTS between two imperfect substitutes like capital & labour.

K

L

MRTS

24

+

2

2:8 or 1:4

16

+

4

2:6 or 1:3

6

+

6

2:4 or 1:2

+

10

2:2 or 1:1

4

No.

Question

Kit book Page No.

1)

Meaning of Production function

6.25

2)

Determinents of Production function

6.28

3)

Types of Production function

6.29

4)

Iso-Cost Line

6.38

5)

Equiliberium of the firm

6.44

6)

Uses of production function

6.48