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Production Function


Production: an activity which transforms inputs into output Four factors of production: land, labour, capital and organization Production Function : technical relationship between quantity of input required and quantity of output produced; Q= f(L, K)

Types of Factor Inputs:

Fixed inputs: remain fixed irrespective of level of production Variable inputs: vary with the level of output

Short run: some inputs are fixed and some are variable Long run: all inputs are variable, no fixed inputs since period is long enough to vary all inputs

Why study Production Function?

To calculate least cost input combination for a given output or maximum output for a given input cost To decide the optimum stage of production for the producer To work out best/ optimum factor input combination for a given level of output To make long run decisions: to increase or decrease the scale of production

Production Function

Studied in 4 ways:

Law of variable proportions (is short run production function) Returns to scale ( is long run production function) Economies of scale Economies of scope

Law of Variable Proportions/ Diminishing Marginal Returns (Short Run Production Function)

Vary one factor input, and keep other factor input fixed/ constant: is in SR Total Product, Average Product and Marginal Product Law of diminishing marginal returns: when increasing units of a variable input are combined with fixed units of another input Relationship between TP, AP and MP curves

Three Stages of Production

Stage 1: Increasing Returns: from beginning till the maximum point on AP curve: here MP of labour is positive, TP is rising at increasing rate, MP of fixed input (capital) is negative and hence it is still useful to employ more labour in this stage, producer is making best use of the fixed factor Stage 2: Diminishing Returns: starts where AP starts to fall and ends where MP curve intersects X axis, i.e. MP becomes zero: here MP of labour is positive and marginal returns to capital has also become positive since TP curve is still rising though at a declining rate, hence producer is making optimal use of both factors Stage 3: Negative Returns: starts when MP becomes negative and TP starts to fall

Stage 2 is the most economical stage for a producer since here returns to both factors is positive and TP is still rising (though at a declining rate) In stage 1, TP is still rising and returns to capital is negative, capital is underutilized In stage 3 TP is falling

Hence stage 2 is the optimal/ efficient stage for the producer

How much of a variable input to be employed?

Marginal Revenue Product of a factor = change in TR as a result of employing one more unit of that factor = MR (or SP of the product)*MP of that factor MRP is downward sloping, convex curve Should employ that much amount of a factor where its MRP = its price i.e. MR = MC (or MW, wage rate remaining constant) So for labour, hire amount of labour till MRP of labour = wage rate

Law of Returns to Scale (Long run production function)

Returns to scale: represents magnitude of change in output relative to proportionate changes in all inputs (scale), change all factor inputs, possible in LR

increasing returns to scale: when output increases more than in proportion to increase in input, due to better efficiencies/ specialization in utilization of factors decreasing returns to scale: if increase in output is in lower proportion, i.e. when operations become unwieldy constant returns to scale: when increase in output is in equal proportion, economies and diseconomies neutralize

Isoquant: curve that outlines all possible combinations of the two factor inputs which produce the same level of output MRTS: is falling since more and more quantity of one factor is required to substitute the same quantity of the other factor Isocost: like the budget line, defines the outlay of the firm on the two factor inputs, given their prices Optimal input combination: at the point of tangency of the isocost with the isoquant Change in expenditure budget of firm: causes a parallel shift in isocost Change in price of a factor input: rotates isocost on that axis

Economies of Scale

When increase in output reduces cost per unit

Fixed costs spread over larger output (scale) reduces cost per unit Efficiencies/ advantages associated with expansion in scale May be :

Internal : due to firms own expansion, unrelated to other firms in industry External: due to expansion of industry, advantages flow to all firms therein

Internal Economies of Scale

Technical Economies: better utilisation of plant and machinery, economies of linked processes Marketing economies: strong bargaining power, lower distribution costs Managerial economies: more specialists Inventory Economies: keeping same spare inventory/ replacement spares for more no. of machines Risk bearing economies: more capacity to bear and spread risks Economies of welfare: better facilities for workers Pecuniary/ financial Economies: result from lower costs of raw materials supplied, of loans obtained, of transportation, advertising etc., due to bulk orders

External Economies of Scale

Technical Economies: when industry expands, better processes used, so all firms benefited, more specialization possible Economies of Information : common research facilities, journals etc. due to larger industry size Economies of By- Products: advantages of waste management, other firms enter to use their wastes for making by products Pecuniary Economies: result from reduction in factor prices due to large size of the industry making larger purchases, cheaper transportation, electricity etc.

Diseconomies of Scale

When larger output results in higher cost per unit. There is a limit to expand production; after a point, increased production will cause diseconomies, from over utilization of resources

Internal: managerial, technical, marketing External: shortage of factors due to industry overexpansion

Economies of Scope

Economies of Scope: cost savings or decrease in per unit cost from adding on a product line related to existing range Joint production: when more than one product can be made from common production process/ resources/ technology, cost may be lowered by producing them together instead of producing them separately Underutilized capacity of one product utilized for production of related product