Production Analysis

Theory of Production

Presented By: Palash Roy ITS - GHAZIABAD

Introduction Whatever be the objective of business firms, achieving optimum efficiency in production or minimizing the cost of production is one of the prime concerns of managers today. Infact, the very survival of the firms in a competitive market depend on their ability to produce at a competitive cost.



In their effort to minimize the cost of production, the fundamental questions which managers are faced with are: 



 





How are the Production and Costs related ? Does substitution between the factors affects the Cost of Production? How does the technology i.e., factor combination matters in reducing the cost of production ? How can the least cost combination of inputs be achieved ? What happens to rate of return when more plants are added to the firm ? What are the factors which create economies and diseconomies for the firm ?

The theory of production provide answers to these questions by providing tools and techniques to analyze the production conditions and to provide solution to the practical business problems.

11/25/09

3

Some Basic Concepts Production: 

Production means transforming inputs ( Labour, Machines, Raw materials etc.) into an output.

Input and Output: 



An input is a good or service that goes into the process of production. Land, Labour, Capital, Management, Entrepreneur and Technology are classified as inputs. An output is any good or service that comes out of the production process.

Fixed Inputs & Variable Inputs:  

Fixed inputs remains fixed (constant) up to certain level of output. Variable inputs change with the change in output.

Short Run and Long Run:  

Short run refers to a period of time in which supply of certain inputs i.e., plant, building and machinery etc. is fixed or inelastic. Long run refers to a time period in which the supply of all the inputs is elastic or variable.

11/25/09

4

Production Function 

Production function is defined as “the functional relationship between physical inputs ( i.e., factors of production ) and physical outputs, i.e., the quantity of goods produced”.



Production function may be expressed as under: Q = f ( K,L) Where ; Q = Output of commodity K = Capital. L = Labour. f = Functional Relationship.

11/25/09

5



Production function depends on : • • • • • •

11/25/09

Quantities of resourses used. State of technical knowledge. Possible process. Size of firms. Relative prices of factors of production. Combination of factors.

6



The following points may be emphasized: • Production function represents a purely technical relationship. • Output is the result of joint use of factors of production. • Combination of factors depend on the state of technical knowledge.



Every management has to make choice of the production function which gives average cost and maximum average profit.

11/25/09

7

Laws of Production

 Laws of production are of two types:  

11/25/09

The law of variable proportions. Laws of returns to scale.

8

Short Run Production Function: The Law of Variable Proportions Statement of the law: “The law of variable proportions states that when more and more units of the variable factor are added to a given quantity of fixed factors, the total product may initially increase at an increasing rate reach the maximum and then decline”.

11/25/09

9

Tabular Presentation of Law of Variable Proportions

Units of Labour

TP

MP

AP

1

80

80

80

2

170

90

85

3

270

100

90

4

368

98

92

5

430

62

86

6

480

50

80

7

505

25

72

8

505

0

63

9

495

-10

55

10

470

-25

47

11/25/09

I Stage

II Stage

III Stage

10

Diagrammatical Presentation of Law of Variable Proportions

AP AP

Assumptions of the law: State of Technology remains the same. Input prices remain unchanged, Variable factors are homogeneous.

MPMP

11/25/09

11

Law of Diminishing Returns and Business Decisions



A Rational producer will never choose to produce in stage III where Marginal Productivity of variable factor is negative. It will stop at the end of the second stage where Marginal Productivity of the variable factor is Zero. At this point the producer is maximizing the total output and will thus be making the maximum use of the available variable factors.



A producer will also not choose to produce in Stage I where he will not be making full use of the available resources as the average product of the variable factor continues to increase in this stage.



A producer will like to produce in the second stage. At this stage Marginal and Average Product of the variable factor falls but the Total Product of the variable factor is maximum at the end of this stage. Thus stage II represents the stage of rational producer decision.

11/25/09

12

Long Run Production Function: The Returns to scale



The long run production function is termed as returns to scale. In the long run, the output can be increased by increasing all the factors in the same proportions.



The laws of returns to scale is explained by the help of Isoquant curves. An Isoquant curve is the locus of points representing various combination of two inputs, Capital & Labour, yielding the same output.



There are three technical possibilities; a) Total output may increase more than proportionately: Increasing returns to scale, b) Total output may increase at a constant rate: Constant Returns to Scale, c) Total output may increase less than proportionately: Diminishing returns to scale.

11/25/09

13

Three Stages of Law of Diminishing Returns

Marginal Product

Constant Returns Increasing Returns

Diminishing Returns

Scale of Inputs

11/25/09

14

ISOQUANTS Isoquant is one way of presenting the production function where two

factors of production are shown. It represents all possible input combinations of the two factors, which are capable of producing the same level of output. Y

C A P I T A L

a ΔK ΔL

ΔK

b ΔL

ΔK

c ΔL

d IQ

O

LABOUR

X

Properties of Isoquants  Negatively sloping curve  Convex to the origin  Cannot intersect each other

11/25/09

16

Marginal Rate of Technical Substitution

 The substitutability of one factor for another

is given by the slope of Isoquant, and is known as MRTS  Slope of Isoquants shows how many extra units of capital must be employed to replace one last unit of labour so that the output remains the same  Thus MRTS (L for K) = ∆K ∆K 11/25/09

17

 The concept of diminishing MRTS in

production stems directly from the law of diminishing marginal returns, which states that as increasing quantities of variable inputs are added to a fixed quantity of other factors, the output per additional unit of the variable factors will eventually decline.

11/25/09

18



Marginal rate of technical substitution indicates the rate at which factors can be substituted at margin in such a way that the total output remains unaltered.



MRTS of L for K is defined as the quantity of K which can be given up in exchange for an additional unit of L, so that level of output remains the same.



The MRTS at a point on the isoquant can be measured by the slope of isoquant at that point.



Slope of IQ at point b = ΔK/ΔL.



MRTS = Slope = ΔK/ΔL.



As output remains the same at every point of isoquants so loss in physical output from a small reduction in K will be equal to the gain in physical output from a small increment in L.

11/25/09

19



Thus, Loss of output = Gain of output i.e. [(Reduction in K ) X (MPP of K)] = [(Increment in L) X (MPP of L)] OR, ΔK X MPK = ΔL X MPL ΔK = MPL ΔL MPK OR,

MRTSLK = MPL ( By definition ΔK = MRTS LK = Slope of isoquant at that point ) MPK ΔL Thus, MRTSLK is the ratio of marginal physical productivities of the two factors.

11/25/09

20

Iso-Cost Lines 



It shows all the combinations of the two factors ( say labour and Capital) that the firm can buy with a given set of prices of two factors. It plays an important role to determine combinations of factors, the firms will choose for production ultimately to minimize cost. Y P R I C E

C

OF C A P I T A L

B A

O 11/25/09

D E E

F

PRICE OF LABOUR

X 21

Producers Equilibrium or the Least Cost Combination of Factors 

A producer desires to minimize his cost of production for producing a given level of output with the least cost combination of factors.

Y

C A P I T A L

A S

How producers ultimately arrives the point of equilibrium ? •The equilibrium is achieved at the point Where MRTS LK = PL/PK ie • The slope of isoquant =Slope of isocost •Or , MRTS LY = MPL = PX MPK PY Or, MPL = MPK PX PY

P

E

T O 11/25/09

R

LABOUR

IQ1 B

IQ IQ2 X

22

Expansion Path  

The Line joining the least cost combinations like a, b, c, d. Expansion Path may be defined as the locus of efficient combinations of the factors. y

C C A P I T A L

B c

IC2

b

A

IC1 a

o 11/25/09

Expansion Path

IC

D E LABOUR

F

x 23

a) Increasing Returns to Scale: C A P I T A L

Labour

Causes:  

11/25/09

Indivisibilities of Factors, High degree of specialization,

24

b) Constant Returns to Scale

C A P I T A L

Causes:  

Factors of production fully utilised. Technology remains unchanged

Labour

11/25/09

25

c) Diminishing Returns to Scale

C A P I T A L

Labour

Causes:  

11/25/09

Managerial Diseconomies. Scarce and Exhaustible resources.

26

Economies & Diseconomies of Scale



The Factors which cause the operations of the Laws of Returns to Scale are grouped as under;

Economies of Scale, relates to profit accruing to a business firm. Economies of scale are classified as;  Internal economies  External economies, 

11/25/09

27

 Internal Economies 

  

Economies in production • Technical advantages, • Advantages of division of Labour and specialization Economies in Marketing Managerial Economies Economies in Transportation & storage

11/25/09

28

 External Economies to large size firms arise

from the discounts available to it due to;  Large scale of purchase of raw material,  Finance at low rate of interest,  Low advertising cost,  Low Transportation cost.  Diseconomies of scale are the losses

accruing to a business firm as a result of large scale production. 11/25/09

29

Oligopoly Market

11/25/09

30

Price and Output Determination Under Oligopoly 

Oligopoly is defined as the market structure in which there are a few sellers selling a homogeneous or differentiated products.



Selling homogeneous products – pure oligopoly. Example : industries producing bread, cement, steel, petrol, cooking gas, chemicals, aluminium and sugar.



Selling differentiated products – differentiated oligopoly. Examples: Automobiles, TV sets, soft drinks, computers, cigarettes etc.

11/25/09

31

Features of Oligopoly 

Small number of sellers : There is a small number of sellers under oligopoly. Conceptually, however, the number of sellers is so small and the market share of each firm is so large that a single firm can influence the market price and business strategy of the rival firms



Interdependence of decision making : The competition between the firms takes the form of action, reaction, and counteraction between them. Since the number of firms in the industry is small, the business strategy of each firm in respect of pricing, advertising, product modification is closely watched by the rival firms

11/25/09

32

Conti…  Barriers to entry arise due to such market    

conditions as : Huge investment required Economies of scale Strong consumers loyalty Existing firms can resort to the price cutting

11/25/09

33

Collusive Oligopoly: Cartels In order to avoid uncertainty arising out of interdependence and to avoid price wars and cut throat competition, firms working under oligopolistic conditions often enter into an agreement regarding a uniform price – output policy to be pursued by them. The agreement may be either formal or secret. when the firms enter into such secret agreements, collusive oligopoly prevails. Collusion is of two types:  

a) Cartels. b) Price Leadership.

In a cartel type of collusive oligopoly, firms jointly fix a price and output policy through agreements. Under Price Leadership one firm sets the price and others follow it. The one which sets the price is a price leader and the one who follow him are his followers.

11/25/09

34

Price and output determination under cartel: - Joint profit maximization

11/25/09

35

Price and Output Determination Under Low-Cost Price Leadership.

11/25/09

36

Price Leadership By The Dominant Firm

11/25/09

37

The Kinked Demand Curve Theory of Oligopoly 

The Kinked Demand Curve Hypothesis was put forward by Paul M. Sweezy & by Hall & Hitch.

11/25/09

38