Session 4: Production
Introduction
• Production is a process of converting the inputs
in the finished output.
• It results in the addition of ‘value’ in terms of ‘use
value’ as well as ‘exchange value’.
• ‘use value’ may be created for self-consumption
by a producer. When the producer creates for the
sale in the market , it has an exchange value.
• Exchange value may be crated by changing the
form of an item or changing its location and
bringing it closer to the buyers or through
storage, packing, manufacturing or some other
form of processing,
Factors of Production
• Production of goods and services needs
various inputs which are known as ‘factors
of production’, ‘agents of production’ ,
‘productive resources’ or sometimes even
‘productive services’.
• The level of production depends upon both
the quantity of inputs and the efficiency
with which they are employed in the
process of production.
• all the units of a ‘factor’ are
‘homogeneous’ so far as their productive
capacity is concerned. They are perfect
substitutes of each other.
• Replacing one unit by another does not
change the total output.
• Four factors of production are ‘land’,
‘labour’, ‘capital’ and ‘entrepreneurship’
The Theory of Production
• Theory of production basically consists of
how the producer, given the state of
technology combines various inputs to
produce a definite amount of output in an
economically efficient manner.
• Qx = f( K,L,….)
• Two main alternative approaches
Laws of Returns or Laws of Variable
Proportions;
Laws of Returns to Scale
Short run and long run
production function
• Short run is defined as that time period
during which a firm cannot vary the
quantities of all inputs. Q = 2000
+3X+5Y2-0.2Z3
• On the other hand, the term “long run” is
defined as that time period over which a
firm can vary all factors of production and
therefore, can choose between different
‘scales’ or ‘sizes’. Q = 2X+3.5Y2-2Z3
Difference between proportion and
scale
In the S. run production
function, some factors are
fixed and some variable so
the proportion of variable
factor to given fixed factor
keeps on changing.
Example:-1/3,2/3,5/3, 7/3 ---etc.
As a result, the firm will
experience Laws of
variable proportions.
Labor Capital
in
in units
units
01
3
02
3
05
3
07
3
Scale– In the long run, no factors are
fixed ,all are variable so what changes
is scale of inputs.
Units of Units of
Here it is assumed that
labor
capital
complementarities and
2
3
substitutability between
4
6
factors are given.
Example—Suppose
6
9
Q = 2L . 3K
10
15
Thus the ratio of L / K
12
18
does not change ,what
alters is scale of inputs.
In the short run Plant capacity is given so
output can increase only by employing more
labor.
___
TP = f ( K ,L )i.e. total product is total quantity
produced by that many units of a variable factor say L.
AP = TP/ L i.e. total output divided by number of units of
a variable factor.
MP =d ( TP ) / d L i.e. change in total output resulting
from using one more/less unit of a variable factor. Since
labor is a variable factor in the short run, it is MP(L) =
(d Q / d L ).
Following table shows relation between TPP,
APP and MPP in S. run.
Labor TPP
0
0
APP
---
MPP
-----
1
15
15
15
2
31
15.50
16
3
48
16
17
4
59
14.75
11
5
68
13.60
09
7
73
10.42
2.5
8
72
9.0
-1
9
70
7.77
-2
10
67
6.70
-5
Law of diminishing returns---
Relation between TP,AP &MP--
3 stages of production
Stage 1 –when all the 3 TP ,AP and MP show
increasing returns.
TPP first rises at an increasing rate in stage 1and
then at diminishing rate; both AP and MP rise and
MP reaches a peak and even starts falling and
becomes equal to AP at the end of 1st stage.
Stage 2---TP continues to rise at diminishing rate
and reaches saturation; AP continues to rise but
slowly; MP falls sharply and even becomes equal
to zero.
Stage 3—TP absolutely falls, AP falls but gently
and MP becomes negative.
If at all the firm has to make a choice, which stage
will the firm select ?( or where will it stop use of
variable factor ?)
The firm will be utilizing variable factor
optimally only when it is in Stage 2
Because in this stage, TP is rising ,AP is rising too and
MP >Zero / +.
A rational firm should employ variable factor till MR >
OR = MC.
MR= MP of L multiplied by MP of Q.
MC =( d TC / d L ).
Producer’s equilibrium
Producer’s equilibrium—A producer is said
to be in equilibrium when An Iso-quant is
tangent to budget line.
Iso-quant is a geometric presentation of
production function. It shows alternative
combinations of 2 factors producing a
given level of Q.
An Input-output Schedule
combin
L
Assuming that Labor & ation
units
Capital are perfect
1
1
substitutes ,one can
derive different
2
2
combinations of L&K
leading to Q =Two
3
3
quintals. Here MRTS
represents d K / d L.
4
4
K
units
16
MRT
S
11
5
7
4
4
3
-----
5
5
2
2
6
6
1
1
MRTS (of labor for capital )
represents slope of an Iso-quant.
Properties of an Iso-quant
1)An Iso -quant is
downward sloping
from L to R,
2) it has negative slope,
3) it is convex to origin,
4) no two iso- quants
intersect ,
5) Iso quant measures
actual volume of
output.
Iso-cost curves or Budget -Lines
Suppose L&K are 2 factors
of production, then TC
can be shown as--TC=w.L +r.K( here w
stands for wage rate and
r for price of K).
Observe following table
given that:-C=Rs.8000;w=Rs.10/ p.u.
and r=Rs 0.400 p.u.
The table shows different
combinations hired by
producer to produce a
particular level of output
with a given budget.
Labor
units
Zero
Capital
units
20
100
17.5
400
10
800
Zero
An iso-cost line/Budget line shows various
probable combinations of the 2 factors bought by
entrepreneur to produce a given level of output.
An iso-cost map
shows a family of
budget lines.
Higher the size of
budget constraint,
more will be the
output produced
,with bigger
combination of
both factors.
A producer is said to be in equilibrium when
An Iso-quant is tangent to budget-line.
Tangency implies equality in
slopes of Iso-quant( MRTS
LK) & Budget line( w / r).
Lower diagram Equilibrium
while Upper diagram
shows Expansion Path.
When input prices change then producers
take rational decision of replacing costlier
input by cheaper one. This is known as
principle of substitution.
If all inputs are changed simultaneously
(increased /decreased ) the behavior of output
changes. This change can be studied with the
help of Returns to scale.
In the long run, output can be increased by
increasing scale of operations. i.e. increasing all
factors in same proportion and at same time.
Law of returns to scale represent long run
behavior of firm.
IRS, CRS & DRS---IRS :- If output
increases more
than proportionate
to inputs, then IRS
will result.
{ ( d Q /d F) >1 }
CRS –here output &input increases in same
proportions
Therefore { ( d Q / d F ) } = 1.
DRS - In this case output responds less than
proportionately to change in inputs.
{(dQ/dF)} <1
IRS are due to Technical / Managerial
indivisibilities. Example : Specialization of labor.
DRS is due to diminishing returns to management,
top management is overburdened and unable to
co-ordinate efficiently. Another cause may be
exhaustible natural resources; doubling the plant
may not lead to a doubling of Q .
Change in scale of inputs results into changing
scale of output through Laws of Returns to Scale.
A production function defines the relationship
between inputs and maximum amount of
output that can be produced within a given
period of time with a given level of
technology.
A production function can be stated as a table,
schedule or mathematical equation.
2 things are inevitable here :- L and K are imp.
inputs and both are substitutes to each
other. Cobb- Douglas production functiona b
Q = A.K L
(represents constant returns to
scale)
Difference between technical
efficiency and economic efficiency
By technical efficiency is meant the maximum
possible output obtained from a given set of
inputs. If resources are not technically efficient it
may lead to waste of resources.
Economists are concerned with economic
efficiency which implies use of production
process which ensures minimization of costs.
Thus while engineers are concerned with technical
efficiency and economists with economic
efficiency.
Internal economies are of following
types---Technical, commercial, financial,
managerial and risk-spreading
Example of --Technical economies– use of big
machine, better utilization of capacity,
bye-product etc.
Commercial economies— Bulk
purchases and sale, saving transport
costs, procurement costs etc.
Financial economies Float funds
easily, internally as well as
externally
A large firm can diversify products and
spreads risks.
An efficient manager can manage growing
business.
LAC curve falls and reaches its minimum due
to internal economies, however if the firm
continues to expand its business (size)
indefinitely, soon several bottlenecks
emerge and the results are internal
diseconomies of scale
All sorts of cost disadvantages occur
and therefore LAC curve starts rising
Sometimes complexities may reach such heights
that managerial inefficiency may result. Risk
economies emerging from large-scale mechanized
production are more in case of large firms than
small firms.
Small firms offer advantages like skill formation,
family jobs, flexibility, independent and prompt
decision-making etc.
Small firms through co-operation can reap
economies as bulk purchases and sales.
Internal Diseconomies
When scale of operations expand/or firm’s
plant size increases beyond a particular
level, it involves more bureaucracy more red
–tape and lengthens chain of
communication .Thus managerial structure
becomes more cumbersome and reduces
efficiency of management. All this leads to
LAC sloping upwards.
With Entrepreneur as a fixed factor,
diminishing returns are bound to occur.
External economies and
diseconomies
Marshall introduced the concept of external
economies.
Costs of a firm depend not only on its own output
level but also on output level of individual firms.
They are external in the sense that they accrue to
the firm from outside the firm.
Jacob Viner defines external economies as “ those
accruing to the firm as a result of expansion of
output by industry as a whole and which are
independent of their own individual output’’.
External economies lead to lowering of cost
curves of each firm in the industry.
On the other hand external diseconomies
result into shifting of the cost curves
upwards. For ex.0ample ,a general increase
in prices of machinery and equipment, an all
round increase in wages and interest rates
will shift the cost curves up.
Examples of external economies given by
Marshall are:i) improved methods
ii) Improved means of transport
/ organization
iii) Growth of correlated branches of industry/
growth of subsidiary trades
iv ) Economies related to growth of knowledge
Mrs. Joan Robinson provide following examples--Machinery available cheaper when the industry
presents a large market to machine-making
industry
Development of traditional skills leading to large
labor force.
Economies of Scale (volume) Vs
Economies of Scope (Variety)
Economies are cost advantages, such advantages
emerge from either extending scale of production
or exploring the scope of production.
When economies are over-exploited ,the result may
be diseconomies i.e. cost disadvantages.
When a firm expands in size by increasing the scale
of its output ,certain cost advantages accrue to
the firm called as Internal economies.
Economies of scope
Many firms produce a number of different
products. These multiproduct firms use
inputs that contribute simultaneously to the
production of two or more goods. eg. oil and
natural gas are explored from an oil well or a
commercial banks provide a variety of
different financial services. Here economies
of scope are bound to exist.
When C(X,Y) <C(X)+C(Y),here ECONOMIES
OF SCOPE seem to exist.
Thank Q !!!