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 approachesLaws 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 in units

Capital in 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.Here it is assumed that

complementarities and substitutability between factors are given.

Example—Suppose

Q = 2L . 3K

Thus the ratio of L / K does not change ,what alters is scale of inputs.

Units of labor

Units of capital

2 3

4 6

6 9

10 15

12 18

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 APP MPP

0 0 --- -----

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 productionStage 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

Assuming that Labor & Capital are perfect substitutes ,one can derive different combinations of L&K leading to Q =Two quintals. Here MRTS represents d K / d L.

combination

L

units

K

units

MRTS

1 1 16 -----

2 2 11 5

3 3 7 4

4 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 -LinesSuppose 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

Capital

units

Zero 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. { ( d Q / d F ) } < 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 function-

a bQ = 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

externallyA 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 DiseconomiesWhen 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 scopeMany 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 !!!