Economics of Pricing Strategies

Economics of Pricing Strategies

Faculty:Prof. Sunitha Raju

Production Analysis - I

Session Date:13.01.2013

PGDIBS 2012-13

Economics of Pricing Strategies1. 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

Basic Production Concepts

Contd…

PGDIBS 2012-13


2.2. InputsInputs

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


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


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


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)

P1 P2 P3L 2 3 5

K 3 2 4Output is same but methods of input combination

differs.


Contd…

PGDIBS 2012-13

Economics of Pricing Strategies Technically efficient process

P1 P2L 2 3

K 3 3

P1 is technically efficient as less L used compared to P2

P1 P2L 2 1

K 3 4

P1 and P2 are not comparable and both considered as technically efficient

Contd…


PGDIBS 2012-13


Efficient processAmongst the technically efficient processes, the least cost process is defined as Economically efficient process.

Contd…


PGDIBS 2012-13


Short Run Production Function

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 Run Production Decisions

1. Case of one variable inputQ = f (L, K )

a) Decision on output/input levelb) defining technically efficient level of outputc) 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 ABC Company: Total Output and Input RelationsInput Relations

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 ABC Company: Average and Marginal Marginal Products of Labour of Labour

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



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



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

Assume MR = 5 PL = 60

PGDIBS 2012-13


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

LPLQ

QTR

.

PGDIBS 2012-13


Problem Solving 1

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) Tax returns processed / hour1 0.22 1.03 2.44 2.85 3.06 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


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

Production Decisions : Dimensions

Contd…

PGDIBS 2012-13


2. Case of more than one variable input

Efficient combination of inputs

Methodology used is Isoquant

Production Decisions : Dimensions

PGDIBS 2012-13

Economics of Pricing StrategiesIsoquants

2 3 4 5 6

12345

L1

L2

3

1

7

10

12

61210

8

18

23

28

2824

12

28

33

36

3631

14

30

36

40

4042

12

28

33

36

4039

Isoquants show combination of two inputs that can produce same level of outputs

Short run Production Function : Efficient Combination of Inputs

PGDIBS 2012-13


Isoquants

2 3 4 5

12345

L1

L2

3

1

7

10

12

61210

8

18

23

24

12

33

31

14

30

40

4042

12

33

36

4039

2828

28 28

3636

36

Isoquants show combinations of two inputs that can produce same level of outputs

PGDIBS 2012-13


Substitution between L1 and L2 is determined by marginal productivities of L1 and L2

Marginal rate of technical substitution (MRTS) = =

The rate of substitutability between inputs is defined by the shape of Isoquant (ratio of MPL)

L1

L2

Q1

Q2

Q3

2

1

LL

1

2

MPLMPL

PGDIBS 2012-13


Isoquant

L1 L1 L1

L1 and L2 are not perfect substitutes

L2 L2 L2L1 and L2 are perfect substitutes

L1 and L2 are complementary

PGDIBS 2012-13


Isocost

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

.

1

2

L

L

PP

MRTS

1

1

1

12

1

2

1 L

L

L

L

L

L

L

L

PMP

PMP

PP

MPMP

PGDIBS 2012-13


Efficient Combination of inputs

Effect of a change in Input Price

Q2

L1

L2L2L2

L1L1

PGDIBS 2012-13


Problem Solving

Medical Testing Labs, Inc., provides routine testing services forblood banks in the Los Angeles area. Tests are supervised by skilledtechnicians using equipment produced by two leading competitors inthe medical equipment industry. Records for the current year showan average of 27 tests per hour being performed on the Test logic-1and 48 tests per hour on a new machine, the Accutest-3. TheTestlogic-1 is leased for $18,000 per month and the Accutest-3 isleased at $32,000 per month. On average, each Machine is operated25 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

Scale of operation is another source for cost minimization

Identifying optimal scale of operation for a given demand conditions

PGDIBS 2012-13


Long run Production FunctionQ = 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


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.

Economics of Pricing Strategies

Documents

Transcript of Economics of Pricing Strategies