Economics of Pricing Strategies
Production Analysis - I
Faculty:
Prof. Sunitha Raju
Session Date:13.01.2013
PGDIBS 2012-13
Basic Production Concepts
Economics of Pricing Strategies
1.
Defining Production Function

Production is physical transformation of input resources into
goods & services
Inputs →

Process
→ Output
Production function defines the technical relationship
between production inputs and output
Contd…
PGDIBS 2012-13
Basic Production Concepts
Economics of Pricing Strategies
2.
Inputs
 Based on relationship with output, broadly categorise all inputs
into


Fixed inputs (Capital) : same level of input irrespective of
output level (eg : Machinery)

Variable input (Labour) : Varies with output level
Q= f (L, K)
how do changes in input level influence the changes in
output level
Contd…
PGDIBS 2012-13
Basic Production Concepts
Economics of Pricing Strategies
3.
Long Run vs Short Run

Short run

When Production decisions are defined by a given
capacity/capital/technology

Fixed and variable inputs together production determine
production.
decision relates to how much to produce under a given
capacity
Contd…
PGDIBS 2012-13
Basic Production Concepts
Economics of Pricing Strategies
 Long run

When Production decisions are not constrained by a given
technology/capacity

Number of technological options exist. As such, no fixed inputs

Production decision relates to identifying optimum capacity/scale
of operation.
PGDIBS 2012-13
Basic Production Concepts
Economics of Pricing Strategies
4.
Defining Production Process
 A product can be produced by various techniques/methods of
production
 A method in which various inputs are combined is defined by a
‘Process’ or ‘Technique’ (P)
L
P1
2
P2
3
P3
5
K
3
2
4
Output is same but methods of input combination differs.
Contd…
PGDIBS 2012-13
Basic Production Concepts
Economics of Pricing Strategies
Technically efficient process
L
P1
2
P2
3
K
3
3
P1 is technically efficient as less L used compared to P2
L
P1
2
P2
1
K
3
4
P1 and P2 are not comparable and both considered as
Contd…
technically efficient
PGDIBS 2012-13
Basic Production Concepts
Economics of Pricing Strategies

Efficient process
Amongst the technically efficient processes, the least cost
process is defined as Economically efficient process.
Contd…
PGDIBS 2012-13
Short Run Production Function
Economics of Pricing Strategies

A production function defines all technical efficient input-output
combinations

Any improvement in technology results in new production function.
eg: better equipment productivity enhancing training
PGDIBS 2012-13
Short Run Production Decisions
Economics of Pricing Strategies
1.
Case of one variable input
Q = f (L, K )
a) Decision on output/input level
b) defining technically efficient level of output
c) defining economically efficient level of output

Together (a), (b) & (c) will determine ‘how much’ output (Q)
to produce and ‘how much’ inputs to use.
PGDIBS 2012-13
ABC Company: Total Output and
Input Relations
Economics of Pricing Strategies
Amount of Machine
Tools (Fixed)
Amount of Labour
Total Output
5
0
0
5
1
12
5
2
27
5
3
42
5
4
56
5
5
68
5
6
76
5
7
76
5
8
74
PGDIBS 2012-13
ABC Company: Average and
Marginal Products of Labour
Economics of Pricing Strategies
Amount of
Machine Tools
(Fixed)
Amount of
Labour
Total Output
Average Products
of Labour
5
0
0
-
5
1
12
12.0
5
2
27
13.5
5
3
42
14.0
5
4
56
14.0
5
5
68
13.6
5
6
76
12.7
5
7
76
10.9
5
8
74
9.2
PGDIBS 2012-13
ABC Company: Average and
Marginal Products of Labour
Economics of Pricing Strategies
Amount of
Machine Tools
(Fixed)
Amount of
Labour
Total
Output
Average
Products of
Labour
Marginal
Product of
Labour
5
0
0
-
-
5
1
12
12.0
12
5
2
27
13.5
15
5
3
42
14.0
15
5
4
56
14.0
14
5
5
68
13.6
12
5
6
76
12.7
8
5
7
76
10.9
0
5
8
74
9.2
-2
PGDIBS 2012-13
ABC Company: Average and
Marginal Products of Labour
Economics of Pricing Strategies
Assume MR = 5
PL = 60
Amount of
Machine Tools
(Fixed)
Amount of
Labour
Total
Output
Average
Products of
Labour
Marginal
Product of
Labour
MRPL
5
0
0
-
-
-
5
1
12
12.0
12
60
5
2
27
13.5
15
75
5
3
42
14.0
15
75
5
4
56
14.0
14
70
5
5
68
13.6
12
60
5
6
76
12.7
8
40
5
7
76
10.9
0
5
8
74
9.2
-2
PGDIBS 2012-13
Economics of Pricing Strategies

Decision on how much Q to produce
 As long as MPL is positive
 Marginal Revenue Product (MRPL)
→ MRPL ≥ = PL
= MRPL =
= MRL . MPL = PL
 Corresponds to
Q = 68 and L = 5
DTR DQ
= PL
.
DQ DL
PGDIBS 2012-13
Problem Solving 1
Economics of Pricing Strategies
Tax Advisors Inc. has an office for processing tax returns in Pennsylvania.
The following table shows how many tax returns are processed per hour
as the number of CPA (Certified Public Accountants) employed increases
CPAs (L)
1
Tax returns processed / hour
0.2
2
1.0
3
2.4
4
2.8
5
3.0
6
2.7
1.
Should the firm engage the 4th CPA? What should be the optimum number
of CPAs to be engaged?
2.
If the CPA’s earn $35 per hour and the revenue for each tax return processed
is $100, should the firm employ the 4th CPA.
PGDIBS 2012-13
Production Decisions : Dimensions
Economics of Pricing Strategies
1. Given a production function
 Under conditions of recession (output prices are falling), a firm
decides to produce where APL max
 Under conditions of boom (output prices are rising), a firm
produces until MRPL ≥ PL
Conceptualize the rising managerial salaries
Contd…
PGDIBS 2012-13
Production Decisions : Dimensions
Economics of Pricing Strategies
2. Case of more than one variable input
 Efficient combination of inputs
 Methodology used is Isoquant
PGDIBS 2012-13
Short run Production Function : Efficient
Combination of Inputs
Economics of Pricing Strategies
Isoquants
L1
6
5
4
10 24 31 42 39
12 28 36 40 40
3
2
1
10 23 33 36 33
12 28 36 40 36
7 18 28 30 28
3
8 12 14 12
1 2

3
4
5
6
L2
Isoquants show combination of two inputs that can produce
same level of outputs
PGDIBS 2012-13
Isoquants
Economics of Pricing Strategies
L1
6
5
4
10 24 31 42 39
12 28 36 40 40
3
2
1
10 23 33 36 33
12 28 36 40 36
7 18 28 30 28
3
8 12 14 12
1 2
3
4
5
L2
 Isoquants show combinations of two inputs that can produce
same level of outputs
PGDIBS 2012-13
Economics of Pricing Strategies
L1
Q3
Q2
Q1
L2

Substitution between L1 and L2 is determined by marginal productivities of L1 and L2

Marginal rate of technical substitution
DL1
(MRTS) =
=
DL2

MPL2
MPL1
The rate of substitutability between inputs is defined by the shape of Isoquant (ratio of MPL)
PGDIBS 2012-13
Isoquant
Economics of Pricing Strategies
L1
L1
L1
L2
L1 and L2 are not
perfect substitutes
L2
L1 and L2 are perfect
substitutes
L2
L1 and L2 are
complementary
PGDIBS 2012-13
Isocost

Economics of Pricing Strategies
Isocost show the different combinations of inputs (at given
prices) For the same cost outlay.
L1
L2
Any point on Isocost reflects the price ratio of L1 and L2
PGDIBS 2012-13
Efficient Combination of Inputs
Economics of Pricing Strategies
.

MRTS =

MPL2
MPL1
=
PL2
PL1
PL2
PL1
=
MPL1
PL1
=
MPL1
PL1
PGDIBS 2012-13
Efficient Combination of inputs
Economics of Pricing Strategies
Effect of a change in Input Price
L1
L1
L1
Q2
L2
L2
L2
PGDIBS 2012-13
Problem Solving
Economics of Pricing Strategies
Medical Testing Labs, Inc., provides routine testing services for
blood banks in the Los Angeles area. Tests are supervised by skilled
technicians using equipment produced by two leading competitors in
the medical equipment industry. Records for the current year show
an average of 27 tests per hour being performed on the Test logic-1
and 48 tests per hour on a new machine, the Accutest-3. The
Testlogic-1 is leased for $18,000 per month and the Accutest-3 is
leased at $32,000 per month. On average, each Machine is operated
25 days of 8 hours each.
1.
Does the Lab usage reflect optimal mix of Testlogic-1 and Accutest-3.
2.
If the price of tests conducted at the Lab is $6, should the company
lease more machines.
PGDIBS 2012-13
Long Run Production Function
Economics of Pricing Strategies

Scale of operation is another source for cost minimization

Identifying optimal scale of operation for a given demand
conditions
PGDIBS 2012-13
Economics of Pricing Strategies
 Long run Production Function
Q = f (L, K)

Where scale increases, then
 output increases (Increasing Returns to Scale)
by a greater proportion
 output increases (Constant Returns to Scale)
by the same proportion
 output increases (Decreasing Returns to Scale)
by a lesser proportion
PGDIBS 2012-13
Economics of Pricing Strategies
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, the f has decreasing returns to scale.