Production Analysis
What is production?
Factors of production
Production function with one variable
Production function with two variables
Economies of scale and scope
Production
Production - an organized activities of converting inputs
into output or creation of value and utility
Factors of production – Rewards
Land - rent
Labor - wages
Capital - interest
Organization - profit
Production function
Production function –
The functional relationship between physical inputs and
physical output
What do Tata Motors, Reliance Power and SBI , have in
common?
Like every firm,
They must decide how much to produce.
How many people to employ.
How much and what type of capital equipment to
use.
How do firms make these decisions?
Law of diminishing marginal
productivity
– as more and more of a variable input is added
to an existing fixed input, after some point the
additional output one gets from the additional
input will fall.
This means that initially the production function exhibits
increasing marginal productivity
Then it exhibits diminishing marginal productivity.
Finally, it exhibits negative marginal productivity
Production Function
With One Variable Input
Total Product TP = Q = f(L)
TP
Marginal Product MPL =
L
Average Product TP
APL =
L
Production or MPL
EL =
Output Elasticity APL
Production Function
With One Variable Input
Total, Marginal, and Average Product of Labor, and Output Elasticity
L Q MPL APL EL
0 0 - - -
1 3 3 3 1
2 8 5 4 1.25
3 12 4 4 1
4 14 2 3.5 0.57
5 14 0 2.8 0
6 12 -2 2 -1
Production Function
With One Variable Input
Production Function
With One Variable Input
Optimal Use of the
Variable Input
Marginal Revenue
MRPL = (MPL)(MR)
Product of Labor
Marginal Resource TC
MRCL =
Cost of Labor L
Optimal Use of Labor MRPL = MRCL
Optimal Use of the
Variable Input
Use of Labor is Optimal When L = 3.50
L MPL MR = P MRPL MRCL
2.50 4 $10 $40 $20
3.00 3 10 30 20
3.50 2 10 20 20
4.00 1 10 10 20
4.50 0 10 0 20
Optimal Use of the
Variable Input
Production
You are an employer seeking to fill a vacant
position on an assembly line. Are you more
concerned with the average product of labor or
the marginal product of labor for the last person
hired? If you observe that your average product is
just beginning to decline, should you hire any
more workers? What does this situation imply
about the marginal product of your last worker
hired?
Production With Two
Variable Inputs
Production decisions of the firm
Three Steps:
Production Technology
Cost constraints
Input choices
Isoquants
Isoquants show combination of two inputs that
can produce the same level of output.
Properties of Isoquant
Downward sloping
Two isoquants never intersect
Convexity
- MPlabour / MPcapital = - MPL / MPK = ΔK / ΔL
The slope of the isoquant is called the marginal rate of
technical substitution which can be defined as the rate at
which a firm can substitute capital for labour and hold
output constant.
Isoquants Showing All Combinations of Capital and
Labour That Can Be Used to Produce 50, 100, and
150 Units of Output
The Slope of an Isoquant Is Equal to
the Ratio of MPL to MPK
Isocosts
Isocost lines represent all combinations of two
inputs that a firm can purchase with the same
total cost.
C w
C wL rK K L
r r
Isocost Lines Showing the Combinations of
Capital and Labour Available for $5, $6, and $7
Isocost Line Showing All Combinations of
Capital and Labour Available for $25
The slope of an
isocost line is
equal to - PL / PK.
The simple way to
draw an isocost is
to calculate the
endpoints on the
line and connect
them.
The Cost Minimizing Equilibrium
Condition
Slope of isoquant = - MPL / MPK
Slope of isocost = - PL / PK
For cost minimization we set these equal and
rearrange to obtain:
MPL / PL = MPK / PK
Finding the Least-Cost Combination of Capital
and Labour to Produce 50 Units of Output
Profit-maximizing firms
will minimize costs by
producing their chosen
level of output with the
technology represented
by the point at which
the isoquant is tangent
to an isocost line.
Point A on this diagram
Minimizing Cost of Production for qx
= 50, qx = 100, and qx = 150
Plotting a series of
cost- minimizing
combinations of
inputs - shown
here as A, B and C
- enables us to
derive a cost
curve.
Expansion path
Production
Suppose a chair manufacturer finds that the
marginal rate of technical substitution of capital
for labor in production process is substantially
greater than the ratio of the rental rate on
machinery to the wage rate for assembly-line
labor. How should the producer alter the use of
capital and labor to minimize the cost of
production?
The question states that the MRTS of capital for
labor is greater than r/w. Note that this is different
from the MRTS of labor for capital, The MRTS of
labor for capital equals MPK/MPL. So, it follows that
MPK/MPL > r/w, or, written another way, MPK/r >
MPL/w. These two ratios should be equal to
minimize cost. Since the manufacturer gets more
marginal output per dollar from capital than from
labor, he should use more capital and less labor to
minimize the cost of production.
Production
A political campaign manager must decide
whether to emphasize television advertisements
or letters to potential voters in a reelection
campaign. Describe the production function for
campaign votes. How might information about
this function (such as the shape of the
isoquants) help the campaign manager to plan
strategy?
The marginal product of labor in the production
of computer chips is 50 chips per hour. The
marginal rate of technical substitution of hours
of labor for hours of machine capital is 1/4.
What is the marginal product of capital?
Ans
The marginal rate of technical substitution is defined at
the ratio of the two marginal products. Here, we are
given the marginal product of labor and the marginal
rate of technical substitution. To determine the marginal
product of capital, substitute the given values for the
marginal product of labor and the marginal rate of
technical substitution into the following formula:
MRL/MPK = MRTS = 50/MPK =1/4. MRK = 200
Returns to Scale
Measuring the relationship between the scale
(size) of a firm and output
1) Increasing returns to scale: output
more than doubles when all inputs
are doubled
Larger output associated with lower cost (autos)
One firm is more efficient than many (utilities)
The isoquants get closer together
Returns to Scale
Measuring the relationship between the scale
(size) of a firm and output
2) Constant returns to scale: output
doubles when all inputs are doubled
Size does not affect productivity
May have a large number of producers
Isoquants are equidistant apart
Returns to Scale
Measuring the relationship between the scale
(size) of a firm and output
3) Decreasing returns to scale: output less than
doubles when all inputs are doubled
Decreasing efficiency with large size
Reduction of entrepreneurial abilities
Isoquants become farther apart
Returns to Scale
Constant Increasing Decreasing
Returns to Returns to Returns to
Scale Scale Scale
