BUSINESS ECONOMICS

Session 5: PRODUCTION ANALYSIS - II

2. 2.1 Post Work Learning Objective (i) to explore the dimensions of firm level short run production decisions under varying demand conditions. (ii) (iii) to understand efficient combination of inputs to explore the basis of firms decision on scale of

output/production

2.2 2.2.1

Summary Production decisions under varying demand conditions Increasing or decreasing demand conditions influence the supply decisions of a project maximizing firm. Under stable demand conditions, when output/input prices are constant, a firm would chose to produce output corresponding to maximum input productivity, i.e. technically efficient output i.e. where APL is maximum. However, under increasing demand conditions, a profit maximizing firm will be induced to produce output that corresponds to falling input productivity (or falling APL) until MRPL=PL.

This framework is applicable in various situations. In a multi plant firm, where technical efficiencies differ between plants, the output contribution of each plant will be based on the relative values of APL and MPL. In determining the firm level profit maximizing output, the contribution of the plants with higher APL and MPL will be more compared to those plants with lower values of APL and MPL. In terms of cost, this approach of determining output level gets translated into lowest Marginal Cost (MC) assuming constant input-output prices. Q = f (L, K ) Q Q APL = , MPL = L L TC = PK . K + PL . L TC K L = PK . + PL . AC = Q Q Q 1 1 = PK . + PL . APK APL (as APL increases, AC decreases) MC =
TC: Total Cost AC: Average Cost MC: Marginal Cost

TC L = PL . Q Q

= PL .

1 MPK

(as MPL increases, MC decreases) 2.2.2 Efficient combination of inputs

For a business firm, efficient combination of inputs is also a source of cost minimization.

The ratio of marginal productivity (MPL) to the prices (PL) is the basis for determining efficient combination of inputs.

MP1 MP 2 MP 3 MP 4 MPn = = = = .. P1 P2 P3 P4 Pn

The dimension of factor productivities (i.e. marginal productivity of inputs) is analyzed through Isoquant and Iso cost analysis. Given the underlying production function/process, the rate of substitutability between the inputs is defined by the shape of the Isoquant (i.e. ratio of marginal productivities of two inputs for a given level of output). The shape of the Iso cost gives the price ratio of the two inputs. Efficient combination of inputs is defined where the slope of the Isoquant is equal to the slope of the Isocost, i.e. where

MP1 MP 2 = . This would P1 P2

mean that the decision on efficient combination of inputs would be determined by the marginal productivities of inputs relative to their prices.

2.2.3

Firms decision on scale of operation

The scale/size of operation is another source of cost minimization for a business firm.

Under a given technology, the response of output to changes in factor inputs are depicted by the short sum production function. The

business decisions in the short run pertain to identifying profit maximizing output level and efficient combination of inputs. In the long run, the business decisions of the firm pertain to identifying optimum scale of operation under given demand conditions. In other words, a firm should define and decide efficient scale from various technological options. This requires an understanding of how firms output responds to changes in scale of operation.

In relating the above to the long run production function, there are three possibilities. One, when scale increases (corresponds to change in technology/process) output increases by a greater proportion, then we have increasing returns to scale. Two, when scale increases, output increases by a lesser proportion, then we have decreasing return to scale. And three, when scale increases, output increases by the same proportion, then we have constant returns of scale.

2.3

Readings Text Book: Chapter 7

2.4

Learning Activities (i) The First National Bank received 3,000 inquiries following the latest advertisement describing its 30-month IRA accounts in the Boston World, a local newspaper. The most recent ad in a similar

advertising campaign in Massachusetts Business, a regional business magazine, generated 1,000 inquiries. Each newspaper ad costs

$500, whereas each magazine ad costs $125. (A) Assuming that additional ads would generate similar response rates, is the bank running an optimal mix of newspaper and magazine ads? Why or why not? (B) Holding all else equal, how many inquiries must a newspaper ad attract for the current advertising mix to be optimal?

(ii)

Will Truman & Associates, LLC, is a successful Manhattan-based law firm. Worker productivity at the firm is measured in billable hours, which vary between partners and associates. Partner time is billed to clients at a rate of $250 per hour, whereas associate time is billed at a rate of $125 per hour. On average, each partner generates 25 billable hours per 40-hour work week, with 15 hours spent on promotion, administrative, and supervisory responsibilities. Associates generate an average of 35 billable hours per 40-hour work week and spend 50 of revenues generated by partners and, given supervisory requirements, 60% of revenues generated by associates.

(A)

Calculate the annual (50 work weeks) net marginal revenue product of partners and associates.

(B)

If partners earn $175,000 and associates earn $70,000 per year, does the company have an optimal combination of partners and associates? If not, why not? Make your answer explicit and support any recommendations for change.