Production Theory

Production Theory
Lecture Plan
 Objectives
 Production
 Types of inputs
 Factors of production
Objectives
 To examine the economic analysis of a firm’s technology, different
types of inputs and the process of production.
 To help develop an understanding of the distinction between short
run and long run production functions
Production

 The process of transformation of resources (like land, labour, capital and

entrepreneurship) into goods and services of utility to consumers and/or
producers.
 The process of creation of value or wealth through the production of goods
and services that have economic value.
 process of adding value may occur
 by change in form (input to output, say steel into car), or
 by change in place (supply chain, say from factory to dealers/retailer), or
 by changing hands (exchange, say from retailer to consumer).
 Goods includes all tangible items such as furniture, house, machine, food,
car, television etc
 Services include all intangible items, like banking, education, management,
consultancy, transportation.
Polling
• ______ shows the overall output generated at a given level of input:
• (a)    Cost function
• (b)    Production function
• (c)     Iso cost
• (d)    Marginal rate of technical substitution
Current News
Types of Inputs
Technology
 determines the type, quantity and proportion of inputs.
 also determines the maximum limit of total output from a given
combination of inputs.
 at any point of time, technology will be given; impact of technology can be
seen only over a period of time.
 Fixed and Variable Inputs
 Production analysis of a firm uses two distinct time frames:
 the short run: refers to a period of time when the firm cannot vary some of its
inputs.
 the long run., refers to a time period sufficient to vary all of its inputs,
including technology.
 Variable input : that can be made to vary in the short run, e.g. raw
material, unskilled/semi skilled labour, etc.
 Fixed input: that cannot be varied in the short run, e.g. land, machine,
technology, skill set, etc.
Polling
A production function tells the firm
•  A) the maximum it can expect to produce with a given mix of inputs
• .B) the minimum it can expect to produce with a given mix of inputs.
• C) the average it can expect to produce with a given mix of inputs.
• D) the average level of productivity for the firm
Polling
• Which out of the following do not belongs to the goods category?
• A.House
• B. Machine
• C. Education
• D. Building
Factors of Production
5 factors of production
 Land
 Anything which is gift of nature and not the result of human effort, e.g. soil, water,
forests, minerals
 Reward is called as rent
 Labour
 Physical or mental effort of human beings that undertakes the production process.
Skilled as well as unskilled.
 Reward is called as wages
 Capital
 Wealth which is used for further production as machine/ equipment/intermediary good
 It is outcome of human efforts
 Reward is called as interest
 Enterprise
 The ability and action to take risk of collecting, coordinating, and utilizing all the factors
of production for the purpose of uncertain economic gains
 Reward is called as profit
 Organization
 Combination of highly skilled labour and specialized human capital/managerial aspect of
business.
 Reward is called as salary
Production Function
 A technological relationship between physical inputs and physical outputs
over a given period of time.
 shows the maximum quantity of the commodity that can be produced per
unit of time for each set of alternative inputs, and with a given level of
production technology.
 Hence it can be said that production function is:
 Always related to a given time period
 Always related to a certain level of technology
 Depends upon relation between inputs.
 Normally a production function is written as:
 Q = f (L,K,I,R,E)
 where Q is the maximum quantity of output of a good being produced, and
L=labour; K=capital; l=land; R=raw material; E= efficiency parameter.
 Technical efficiency is defined as a situation when using more of one input
with either the same amount or more of the other input must increase
output.
Polling
• Which of the following is an example of an intermediate product?
•  a. A personal computer.
 b. A barrel of crude oil.
 c. A sports car.
 d. A house.
Production Function with One Variable Input

 Also termed as variable proportion production function

 It is the short term production function
 Shows the maximum output a firm can produce when only one
of its inputs can be varied, other inputs remaining fixed:
 Q  f ( L, K )
 where Q = output, L = labour and K = fixed amount of capital
 Total product is a function of labour: TPL  f ( K ,L)
 Average Product (AP) is total product per unit of variable input
 Average product of labour (APL) is:
TP
 Marginal Product (MP) is the addition inAPtotal
L  output per unit
L
change in variable input
 Marginal product of labour (MPL) is:
TP
MPL 
L
Assumptions of Law of Variable proportions

• Imperfect substitutes
• Technology is constant
• Two types of factors
• Optimum production
Law of Variable Proportions
Labour Total Product MP AP Stages
(’00 (’000 tonnes)
units)
200
1 20 - 20 Increasing
2 50 30 returns 150
25 Total Product
(’000 tonnes)
3 90 40 30 100
Marginal

Output
4 120 30 30 Diminishing Product
5 140 20 returns 50
28 Average
Product
6 150 10 0
25
1 2 3 4 5 6 7 8 9
7 150 0 21.5 -50
8 130 -20 16.3 Negative Labour
returns
9 100 -30 11.1
 As the quantity of the variable factor is increased with other fixed
factors, MP and AP of the variable factor will eventually decline.
 Therefore law of variable proportions is also called as law of diminishing
marginal returns.
Law of Variable Proportions

Total
C
First stage
Output Increasing Returns to
B TPL the Variable Factor
MP>0 and MP>AP
A Second stage
Diminishing Returns to
a Variable Factor
O MP>0 and MP<AP
Labour
Total Third Stage
Output Negative Returns
Stage I Stage II Stage III
MP<0 while AP is falling
A* but positive
B
* Technically inefficient
stage of production
APL A rational firm will never
C
O operate in this stage
*L
MP Labour
Applications in Agriculture

•Limited Land
•Less use of machinery
•Natural factors
•Seasonal occupation
•Difference in fertility of land
•Fragmented land and vast area, so requires more supervision
•Less chances of division of labour
•Lack of perfect substitutes
Production Function with Two Variable Inputs

 All inputs are variable in long run Capital Labour

(Rs. crore) (’00 units)
and only two inputs are used
40 6
 Firm has the opportunity to select 28 7
that combination of inputs which 18 8
maximizes returns
12 9
 Curves showing such production 8 10
function are called isoquants or iso-
product curves. 45
40
 An isoquant is the locus of all 35
30

Capital (Rs. Crore)

technically efficient combinations of 25
20
two inputs for producing a given 15
level of output 10
5

 Represented as: 0
6 7 8 9 10

Q  f ( L, K ) Labour ('00 units)

Isoquants

The word 'iso' is of Greek origin and means equal or same and
'quant' means quantity. An isoquant may be defined as:
 
"A curve showing all the various combinations of two factors that
can produce a given level of output. The isoquant shows the
whole range of alternative ways of producing the same level of
output".
 
The modern economists are using isoquant, or "ISO" product
curves for determining the optimum factor combination to produce
certain units of a commodity at the least cost.
Schedule

Combinations Labour(L) Capital(K) Total Output

A 1 14 100 METERS

B 2 10 100 METERS

C 3 7 100 METERS

D 4 5 100 METERS

E 5 4 100 METERS
Iso-quant
Characteristics of Isoquants

 Downward sloping
 Convex to the origin
 A higher isoquant represents a higher output
 Two isoquants do not intersect
 Should not be parallel to either axis
 Should not touch either axis
Capital Capital

C
A

B A Q1
B C
Q2
Q1
Q0 Q2
O
O Labour Labour
Returns to Scale
 Returns to Scale show the degree by which the level of output changes in
response to a given change in all the inputs in a production system.

Panel a Panel b Panel c

Capital Capital Capital
C2
C
B2 C1
B 400Q B1
A 200Q A2 A1 125Q
100Q 150Q
50Q 90Q
50Q 50Q
O O O
Labour Labour Labour
 Constant Returns to Scale : When a proportional increase in all inputs yields an
equal proportional increase in output (Panel a)
 Increasing Returns to Scale : When a proportional increase in all inputs yields a
more than proportional increase in output (Panel b).
 Decreasing Returns to Scale : When a proportional increase in all inputs yields a
less than proportional increase in output (Panel c).
Economies and Diseconomies of scale
• A. Real economies: which result in reduction of physical inputs
I. Technical economies
• Economies of linked process
• Economies of the use of by-products
ii. Marketing economies
iii.Labour economies
iv.Managerial economies
v. Economies of transport and storage
• B. Pecuniary economies
i. Raw materials are purchased on bulk, so, they can get at discounted rate.
ii. Loans at low rate of interest
iii.Concessional transportational services by transport companies.
iv.Bulk advertising
External economies

External economies are those benefits which are shared in by a large number of firms or
industries when the scale of production in any industry increases.
• Economies of concentration
• Economies of information
• Economies of Disintegration
• Economies of Localisation
• Economies of By-products
Polling
When a proportional increase in all inputs yields an equal proportional
increase in output
 Constant Returns to Scale
 Increasing Returns to Scale
 Decreasing Returns to Scale
Diseconomies of scale

All those losses which accrue to the firms in the industry due to the expansion of their output to a
certain limit.
• Internal diseconomies
1. Inefficient management
2. Technical difficulties
3. Production difficulties
4. Marketing diseconomies
5. Financial diseconomies
• External diseconomies
1. Diseconomies of pollution
2. Diseconomies of strains of infrastructure
3. Diseconomies of high factor prices
Cobb-Douglas Production Function
 Proposed by Wicksell and tested against statistical evidence by Charles W.
Cobb and Paul H. Douglas in 1928
 
 Q  AKwhere L α, β are constants. A is the technological parameter, α is the
elasticity of output with respect to capital, and β is the elasticity of output
with respect to labour.
 Properties
 Homogeneous of degree (+)
 The returns to scale is immediately revealed by the sum of the two
parameters  and 
 Constant Returns to Scale: ( +) = 1
 Increasing Returns to Scale: ( +) > 1
 Decreasing Returns to Scale: ( +) < 1
 Isoquants are negatively sloped and convex to the origin
 MRTSLK is a function of input ratio
 Elasticity of substitution is equal to 1
Leontief Production Function

 Represents the extreme case of perfect complements

 ‘L’ shaped or right angled isoquants.
 Also known asL fixed
K coefficient production function
Q  min( , )
 

 Production technology always involves inputs labour (L) and capital (K)
in fixed proportions to produce a unit of output and α and в are the
fixed coefficients
 A certain amount of each input is required technologically to produce
one unit to output
 Demand for inputs is uniquely determined
 Inputs are required in exact quantities per unit of output
 Any change in MRTS will not lead to any change in the factor
proportions: б = 0
CES Production Function

 Constant Elasticity of Substitution (CES) production function

 Introduced by Arrow, Chenery, Minhas and Solow (also known
as ACMS)
 Q=A[αK -ρ +(1-α)L -ρ ] -r/ρ, where:
 A(>0) is the efficiency parameter which represents the "size" of the
production function
 α is the distribution parameter which will help us explain relative factor
shares (so 0<α<1);
 ρ is the substitution parameter, which will help us derive the elasticity
of substitution and
 r is the scale parameter which determines the degree of homogeneity
 Homogeneous of degree r
• The Marginal Value of Free Medical Care
• Certain Americans, such as the elderly and

• those on welfare, receive government-

• subsidized medical care. State and federal

• taxpayers spend over $420 billion a year

• providing medical care to 75 million
• Medicare and Medicaid recipients, for an
• average annual cost of about $5,600 per

• beneficiary.The dollar cost to most benefi-

• ciaries is usually little or nothing. The

• problem with giving something away is

• that beneficiaries consume it to the
• point where their marginal valuation is zero, although the marginal cost to taxpayers can
• be sizeable.
• This is not to say that beneficiaries derive no benefit from free medical care.Although
• they may attach little or no value to the final unit, they likely derive a substantial consumer

• surplus from all the other units they consume. For example, suppose that Exhibit 8 repre-
• sents the demand for medical care by Medicaid beneficiaries. Because the price to them is

• zero, they consume to the point where the demand curve intersects the horizontal axis,
• where their marginal valuation is zero.Their consumer surplus is the entire area under the
• demand curve.
• One way to reduce the cost to taxpayers of such programs without significantly harming
• beneficiaries is to charge a small amount—say, $1 per physician visit. Beneficiaries would

• eliminate visits they value less than $1.This practice would yield significant savings to tax-
• payers but would still leave beneficiaries with excellent health care and a considerable con-
• sumer surplus (measured in Exhibit 8 as the area under the demand curve but above the

• $1 price).As a case in point, one Medicaid experiment in California required some benefi-
• ciaries to pay $1 per visit for their first two office visits per month (after two visits, the price

• of additional visits reverted to zero).A control group continued to receive free medical care.
• The $1 charge reduced office visits by 8 percent compared to the control group.

• Medical care, like other goods and services, is also sensitive to its time cost (a topic dis-
• cussed in the next section). For example, a 10 percent increase in the average travel time to

• a free outpatient clinic reduced visits by 10 percent. Similarly, when the relocation of a free
• clinic at one college campus increased students’ walking time by 10 minutes, visits dropped
• 40 percent.
• Another problem with giving something away is that beneficiaries are less vigilant about
• getting honest value, which may increase the possibility of fraud and abuse.According to a

• study by the U.S. General Accounting Office, about 1 in 7 Medicare dollars is wasted be-
• cause of padded bills and fake claims that recipients would not tolerate if they paid their

• own bills. For example, in one case, the government was billed for round-the-clock cardiac
• monitoring when the patient was in fact monitored only 30 minutes a month.
• These findings do not mean that certain groups do not deserve low-cost medical care.
• The point is that when something is free, people consume it until their marginal valuation
• is zero and they pay less attention to getting honest value. Some Medicare beneficiaries, for

• example, visit one or more medical specialists most days of the week. Does all this medi-
• cal attention improve their health care? Maybe not. Researchers have found no apparent

• medical benefit from so many visits.As one doctor told the New York Times,“The system is
• broken. I’m not being a mean ogre, but when you give something away for free, there is