Production Analysis

Dr. Alok Kumar Pandey

Topics for Discussion

Production Function Total Production, Marginal Production and Average Production Law of Diminishing Marginal Returns Isoquant- Isoquant Schedule, Map Marginal Rate of Technical Substitution Isocost Optimal Combination of Inputs Expansion path Returns to Scale

Production Function

The firms production function for a particular good (q) shows the maximum amount of the good that can be produced using alternative combinations of capital (k) and labor (l)

Example: Q = f (L, K)

Short Run and Long Run

Short run- One factor is variable and others are constant Q = f (L, K*) Long run- All the factors are variable Q = f (L, K)

The Production Function-graphical

Q
Production Function Q = f(L)

Production Set

The Marginal Product

The marginal product of an input is the change in output that results from a small change in an input holding the levels of all other inputs constant.
MPL = Q/L (holding constant all other inputs) MPK = Q/K (holding constant all other inputs)

The Average Product

The average product of an input is equal to the total output that is to be produced divided by the quantity of the input that is used in its production: APL = Q/L APK = Q/K

Total, Average and Marginal Products in the Short Run

Quantity of labour [L] [1] 1 2 3 4 5 6 7 8

Total Product [TP]

[2] 43 160 351 600 875 1152 1375 1536

Average Product [AP] [3] 43 80 117 150 175 192 196 192

Marginal Product [MP] [4] 43 117 191 249 275 277 220 164

9
10 11 12

1656
1750 1815 1860

184
175 165 155

120
94 65 45

Total, average and marginal product curves

2100 1800 Total product [T/P] 1500 200 1200 150 900 600 300 100
Point of diminishing average returns

300 TP 250

Point of diminishing marginal returns

AP

MP 50

4 labour

10

12

4 6 Labour

10

12

[i] Total Product

[ii] Average and Marginal Product

Law of diminishing marginal returns

The law of diminishing marginal returns states that marginal products (eventually) decline as the quantity used of a single input increases. 2 k kk 11 2

MP f f f 0 k k 2 MPl f 2 fll f22 0 l l

Stages of Production

Three stages. First stage- when we vary one factor of production, there is increasing average returns to the factor of production. i.e. MPL> APL ( Marginal product is greater than average product. Second stage: When average product is decreasing marginal product is also decreasing but marginal product is positive. i.e. APL> MPL Third stage: When average product is decreasing but marginal product is negative. i.e. MPL<0

Production indifference curves-Iso-quant

Production indifference curve

Iso-quant All different quantities of two inputs

Given quantity of output

Production indifference Schedule Characteristics

1. 2. 3.

Higher curves - larger outputs Negative slope convex to the origin

ISOQUANT
Labor Input Capital Input 1
1
2 3 4 5

2
40
60 75 85 90

3
55
75 90 100 105

4
65
85 100 110 115

5
75
90 105 115 120

20
40 55 65 75

Production with Two Variable Inputs (L,K)

Capital per year

5
4 3 2

E The isoquants are derived from the production function for output of 55, 75, and 90. A B C

Q3 = 90 1 1 2 3
D

Q2 = 75 Q1 = 55 4 5
Labor per year

Isoquants- Input Flexibility

The isoquants emphasize how different input combinations can be used to produce the same output. This information allows the producer to respond efficiently to changes in the markets for inputs.

Rate of Technical Substitution

Marginal rate of technical substitution (RTS): the amount by which one input can be reduced when one more unit of another input is added while holding output constant (i.e. negative of the slope of an isoquant). It is the rate that capital can be reduced, holding output constant, while using one more unit of labor.

Rate of Technical Substitution

Rate of Technical Substitution (of labour for capital) =RTS (of L for K) = - (slope of isoquants) = - (change in capital inputs)/ (change in labour inputs) RTS (of L for K) = MPK/MPL

A production indifference curve

RTS (of L for K) = MPK/MPL

600 Capital 400 200

B D A IQ

5 Labor

10

A production indifference map

600 Capital 400 200

B D A 220,000 unit

260,000 unit 240,000 unit

5 Labor

10

Production Indifference Curves - Budget

Line

Equally costly input combinations

Given

Budget Input prices

Straight line Same slope Parallel

Budget lines

Isocost
ISOCOST lines are the combination of inputs for a given cost,
Capital 360 J

K 0 Labour 40

Optimal Combination of Inputs

The objective is to minimize cost for a given output Minimize production cost

Given level of output Tangency point

Cost line Isoquant curve (given level of output)

Optimal where:

MPL/MPK = CL/CK Rearranged, this becomes the equimarginal criterion

Optimal Combination of Inputs

Equimarginal Criterion: Produce where- MPL/CL = MPK/CK, where marginal products per dollar are equal

at D, slope of isocost = slope of isoquant C(1) Q(1)

Cost minimization
450
360 Capital 270 225 J A Rs. 450,000

T
Rs. 360,000 240,000 unit

Rs. 270,000
0 15 B 30 Labours K 40 50

Expansion path - locus

Cost-minimizing input combinations

All relevant output levels Production indifference curves Budget lines Output Total cost

Tangency points

For each point on expansion path

The firms expansion path

B

E S

Capital

B S

T
300,000 units
220,000 units

E 0

240,000 units B Labour K

Rs. 270,000 B

10 15

How changes in input prices affect input proportions

Capital

T E 240,000 units

K Labor

Returns to Scale

Evaluating Returns to Scale

Returns to scale show the output effect of increasing all inputs.

Output Elasticity and Returns to Scale Output elasticity is Q = Q/Q Xi/Xi where Xi is all
inputs (labor, capital, etc.) Q > 1 implies increasing returns. Q = 1 implies constant returns. Q < 1 implies decreasing returns.

Returns To Scale

Returns to Scale Estimation

RTS = [%Q]/[% (all inputs)]

If a 1% increase in all inputs results in a greater than 1% increase in output, then the production function exhibits increasing returns to scale.
If a 1% increase in all inputs results in exactly a 1% increase in output, then the production function exhibits constant returns to scale. If a 1% increase in all inputs results in a less than 1% increase in output, then the production function exhibits decreasing returns to scale.

Returns to scale
Capital

(a)

Capital

(b)

Capital

(c)

p2 D 4 C 2 1 0 3 A 6 Labor B p1 8 4 12 2 1 A 6 Labor B p1 10 4 12 2 1 0 A 6 Labor

B p1 6 4
12

Constant returns to scale. Increasing returns to scale. Doubling the levels of both Doubling the levels of inputs more than doubles labor (from 3 to 6) and capital (from 2 to 4) also the output level doubles the level of output (from 4 to 8)

Decreasing returns to scale. Doubling the levels of both inputs less than doubles the output level

The Effect of Technological Improvement

Output per time period

C B

100

O3

Labor productivity can increase if there are improvements in technology, even though any given production process exhibits diminishing returns to labor.

A
50 O2 O1
Labor per time period

0 1

2 3

5 6

7 8

10