E-LESSON-4

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MBA 2 All right are reserved with CU-IDOL MANAGERIAL ECONOMICS Course Code: MBA601 Semester: First SLM UNITS : 5 E-Lesson : 4 www.cuidol.in Unit-5 (MBA601)

PRODUCTION ANALYSIS 33 OBJECTIVES INTRODUCTION Student will be able to : Production and cost analysis together Explain the concept of production. determine the supply of the product to the market. Production is calculated in physical Discuss the various production functions. terms, while the costs are determined in financial terms. Differentiate between short run and long run Production analysis shows the relationship production functions. between physical inputs of the factors of production and the output of the product and Explain Iso-quant analysis. studies the least cost combination of factor inputs and returns to scale, while costs Elaborate the production functions. analysis deals with various types of costs and their role in decision making. www.cuidol.in Unit-5 (MBA601) INASllTITriUgThEt aOrFeDreISsTeArNveCdE AwNitDh OCNUL-IIDNOE LLEARNING

TOPICS TO BE COVERED 4 > Production Function-Types of Production Function > Marginal Rate of Technical Substitution (MRTS) > Equilibrium of the Firm or Producer’s Equilibrium - Choice of Optimal Combination of Factors of Production (‘Iso-quants’) > Expansion Path: (Choice of Optimal Expansion Path) > The Law of Variable Proportions > The Laws of Returns to Scale www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

PRODUCTION FUNCTION 5  Production in economic terms is generally understood as the transformation of inputs into outputs. The inputs are : What the firm buys namely productive resources and outputs are: Which it sells.  The term production function is used to explain the production of products for which we require the services of various factors of production. The factors of production are generally known as land resources, labour, capital and entrepreneurship. These factors of production are termed as inputs. The firm buys inputs and sells outputs. Inputs are those things that firms buy to produce goods. Outputs are the produced goods. The theory of production revolves around the concept of production function.  Production function is defined as the functional relationship between physical inputs (factors of production) and physical outputs (i.e., the quantity of goods produced).  The production function expresses the technological relationship between the quantities of output and the quantities of inputs used in production. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

TYPES OF PRODUCTION FUNCTION 6 There are three types of production function: (i) Fixed proportion and Variable proportion production function. (ii) Short period and Long period production function. (iii) Cobb-Douglas Production Function. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

FIXED PROPORTION AND VARIABLE 7 PROPORTION PRODUCTION FUNCTION  Fixed proportions of production function: The Fixed Proportion Production Function, also known as a Leontief Production Function implies that fixed factors of production such as land, labor, raw materials are used to produce a fixed quantity of an output and these production factors cannot be substituted for the other factors.  Variable proportions of production function: The Variable Proportion Production Function implies that the ratio in which the factors of production such as labor and capital are used is not fixed, and it is variable. Thus, the labor can be substituted for any other factors. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

SHORT PERIOD AND LONG PERIOD PRODUCTION 8 FUNCTION  In the short period, one or more inputs are fixed. In order to produce more units of output, the management has to increase the variable factor. For example, machinery is fixed and labour input is variable. In this case, the quantity of machinery cannot be increased in the short period. Then the only possibility is to increase labour inputs.  In the long period, all factor inputs can be varied. In the long period, the management can choose between increasing production through the use of more labour or through plant expansion, depending upon which the combination of labour and plant size. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

COBB-DOUGLAS PRODUCTION FUNCTION 9  In Cobb-Douglas production function, the output is goods produced by the manufacturing industries. The inputs are labour and capital. The Cobb-Douglas formula says that labour contributes about 75 per cent increase in manufacturing production, while capital contributes only 25 per cent. The formula is as follows: P = bLaC1-a Where P = Total output, L = Index of employment of labour in manufacturing C = Index of employment of capital in manufacturing a and 1-a = exponents of elasticities of production i.e., a and 1-a measure percentage response of output to percentage change in labour and capital respectively. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

MARGINAL RATE OF TECHNICAL SUBSTITUTION 10 (MRTS)  The substituting of one input for another without changing the level of output is called as marginal rate of technical substitution. The scope of iso-quant curve is measured in terms of MRTS. The MRTS of factor x (labour) for a unit of factor y (capital) may be defined as the amount of factor y which can be substituted or replaced for a unit of factor x without changing the level of output. Thus, in terms of inputs of capital (K) and labour (L) MRTS =change in L/change in K MRTS is similar to MRS i.e., marginal rate of substitution in indifference curve analysis. MRTS diminishes always. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

ISO COST LINE 11  An ISO cost curve is a curve or line representing equal cost. An ISO cost line is so called because, it shows all combinations of inputs having equal total cost. The ISO cost lines are straight lines which means that the firm has no control over the prices of the inputs and the prices are the same irrespective of the units of inputs bought by the firm. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

Equilibrium of the Firm or Producer’s Equilibrium 12 - Choice of Optimal Combination of Factors of Production (‘Iso-quants’)  A producer or a firm is said to be in equilibrium, when it is able to produce more (highest) output with the given outlay and given factors of production or inputs of production. A rational producer may attain equilibrium either by maximizing output for a given cost or minimising cost subject to a given level of output. In order to determine the producer’s equilibrium, we should integrate an iso-quant map with an iso cost line. An iso-quant is the locus of all the combinations of two factors of production that yield the same level of output. Isoquant map refers a group of isoquants, each representing different levels of output. An isocost line represents various combinations of two inputs that may be purchased for a given amount of expenditure. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

Equilibrium of the Firm or Producer’s 13 Equilibrium - Choice of Optimal Combination of Factors of Production (‘Iso-quants’) Maximisation of output for a given cost: A rational producer will always try to maximise his output for a given cost. This can be explained with the help of a diagram. Let AB (iso cost line) in the figure represent given cost outlay. IQ1 , IQ2 , IQ3 are isoquants representing three different levels of output i.e., 1,000, 2,000 and 3,000 units respectively. IQ3 i.e., 3,000 units levels of output is not attainable because it is out of reach of the producer (the given cost outlay is only AB). In fact, any output level beyond isocost line AB is not attainable. Now the producers firm reaches the equilibrium position at E where the iso-cost-line is tangent to IQ2 . At this stage he employs 0K amount of capital and 0L of labour to produce 2,000 units of output. Therefore, by using oK of capital and 0L of labour, the producer reaches the highest level of production possible given the cost conditions. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

Equilibrium of the Firm or Producer’s Equilibrium - Choice of Optimal Combination of Factors of Production 14 (‘Iso-quants’) Minimisation of Cost for a Given Level of Output: The producer or the firm may seek to minimize the cost of producing a given amount of output. In both the cases (maximization of output and minimization of cost) the condition of equilibrium remains the same. That is the marginal rate of technical substitution must be equal to the factor price ratio. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

EXPANSION PATH: 15 CHOICE OF OPTIMAL EXPANSION PATH  “Expansion path is that line which reflects least cost method of producing different levels of output.”  By using different combinations of Capital factors (inputs) a firm can produce different levels of output. Among these, the combination of factors which is optimum will be used by the firm and it is called as ‘Expansion path’. It is also called as ‘scale-line’. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

Expansion Path: (Choice of Optimal Expansion Path) 16 Units of labour employed is measured along the X axis and capital employed is measured along the Y axis. The first iso-cost line of the firm is AB. It is tangent to IQ at point e1, which is the initial equilibrium of the firm. Supposing the price per unit of labour and capital remains unchanged and the financial resources of the firm increases, the firm’s new iso-cost line shifts to right as CD. In this situation new iso- cost line CD will be parallel to the initial iso-cost line AB and tangent to IQ2 at point e2 which will be the new equilibrium point now. If the financial resources of the firm further increases, but the price of the factors remaining the same, the new iso-cost line will be FG. It will be tangent to the iso-quant IQ3 at point e3 which will be the new equilibrium point of the firm. By joining all the equilibrium points we get a line (PP) called scale-line or expansion path. It is called so because a firm expands its output or scale of production in conformity with this line. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

EXPANSION PATH: 17 (CHOICE OF OPTIMAL EXPANSION PATH) Cost Minimization: The firm wants to produce any amount of output at the least cost. This is obtained by the point of tangency of the isoquant to an ISO cost line. In other words, minimum costs mean that isoquants are tangents to ISO cost lines. This is explained in the next slide with diagram: www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

18  In the diagram, the maximum output is obtained at a point of tangency between isoquant and ISO cost lines. N, M, L are the points of tangency. The firm expands output along the line D. At the point of N output, the firm buys OX1 and OY1 inputs. This is the optimal combination of inputs. At this point, the marginal rate of substitution between inputs is equal to the ratio between the prices of the inputs. The minimum cost is represented by the point of tangency between the isoquant and ISO cost line. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

THE LAW OF VARIABLE PROPORTIONS  This law examines the production function with one factor input variable, while other factor inputs remain1 9 unchanged.  The law of variable proportions is defined as follows, ‘As the quantity of one input is increased, keeping the quantity of other inputs fixed, the output increases in the beginning and afterwards decreases.’  Samuelson defined it as ‘An increase in some inputs relative to other fixed inputs will, in a given state of technology, cause output to increase; but after a point, the extra output resulting from the same additions of extra inputs will become less and less.’ www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

ASSUMPTIONS OF THE LAW OF VARIABLE PROPORTIONS 20  The state of technology of production remains unchanged. If there is an improvement in the technology of production, the marginal and average product may increase instead of diminishing.  Some inputs are kept fixed during the process of production. It is only in this way that factor proportions are altered to know its effect on output. The law does not apply if all factor inputs are proportionately varied.  The law is based on the possibility of varying the proportions in which various factors can be combined to produce a product. This law does not apply to cases where the factor inputs have to be used in fixed proportions to yield a product. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

LAW OF VARIABLE PROPORTIONS 21  . It may be seen that the marginal product is rising initially but later, it starts declining. Decreasing Increasing Returns Stage  In the stage I, total product increases at an increasing rate. The first stage is known as the stage of increasing returns, because the average product of the variable factor is increasing throughout this period Returns Stage  In the stage II, the total product continues to increase, but at a diminishing rate. This stage is called the stage of diminishing returns as both the average and marginal products of the variable factor continuously fall.  Negative Returns Stage  In the stage III, total product declines and therefore the total product curve slopes downward. As a result, the marginal product is negative and the MP curve goes below OX axis. The average product decreases still further. This stage is called the stage for negative returns. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

LAW OF VARIABLE PROPORTIONS 22 The Stage of Operation: The question is which stage of operation is rational for production. A rational producer will not choose to produce in the stage III. At the end of stage II at the point M, the marginal product and thus will be making the maximum use of the variable factor. In the stage I, the producer will not be making maximum use of fixed factor and he will not be utilizing fully the opportunities of increasing production by increasing the quantity of variable product, whose average product continues to rise throughout the stage I. Thus, a rational producer will not stop in the stage I, but will expand further. At the point N, the marginal product to the variable factor is the maximum and at the end point N of the stage I, he will be making maximum use of the fixed factor. So long as the average product, marginal product and total product are rising, the entrepreneur will not stop producing. Therefore, he goes to stage II, where both marginal product and the average product of the variable factor are diminishing. The stage II represents the range of rational production decisions. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

THE LAWS OF RETURNS TO SCALE  In the laws of returns to scale, all productive factors or inputs are increased or decreased in the same2 3 proportion simultaneously. In returns to scale, we analyse the effect of doubling or tripling, quadrupling and so on of all inputs on the output of the product. The study of changes in the output as a consequence of changes in the scale, forms the subject matter of ‘Returns to Scale’. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

THE THREE PHASES OF RETURNS TO SCALE 24 www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

THE THREE PHASES OF RETURNS TO SCALE 25 Increasing Returns to Scale:  Increasing returns to scale means that output increases in a great proportion than the increase in inputs. for example, if all inputs are increased by 25 per cent, the output increases by 40 per cent, then the increasing returns to scale is prevailing.  One chief reason for this increase is the effect of technical and managerial indivisibility. Indivisibility means that equipment is available only in minimum sizes and the firm has to start producing from the minimum size of equipment.  Another cause for increasing lies in dimensional relations.  Lastly increasing returns to scale comes from higher degree of specialisation. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

THE THREE PHASES OF RETURNS TO SCALE 26 Constant Returns to Scale: If the scale of inputs are increased in a given proportion and the output increases in the same proportion, returns to scale are said to be constant, i.e., doubling of all inputs, doubles the output. In mathematics, the case of constant returns to scale is called linear and homogeneous production function or homogeneous production function of the first degree. In some industries, expansion of output produces no net economies and the cost of production remains the same. Such industries are said to be governed by the law of constant returns. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

THE THREE PHASES OF RETURNS TO SCALE 27 Diminishing Returns to Scale:  When the output increases in smaller proportion than the increase in all inputs, decreasing returns to scale is said to prevail. When a firm goes on expanding by increasing all its inputs, then eventually diminishing returns to scale occurs.  Some economists are of the view that the entrepreneur is one fixed factor, while all other inputs are variable factors. But the entrepreneur factor cannot be increased. On this view, they say that the law of diminishing returns is the special case of the law of variable proportions.  Other economists do not subscribe to this view, but they say that diminishing returns to scale occur because of increasing difficulties of management, coordination and control. When the firm becomes gigantic, it is difficult to manage it with the same efficiency as before. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

SUMMARY 28  Production refers to transformation of inputs into outputs.  The production function expresses the technological relationship between the quantity of output and the quantities of inputs used in production.  An Iso-cost curve is a curve or line representing equal cost i.e., it shows all combinations of inputs having equal cost.  An iso-quant is the locus of all the combinations of two factors of production that yield the same level of output.  Expansion path is that line which reflects least cost method of producing different levels of output.  A producer may maximize his output for a given cost or minimize the cost for a given level of output.  Law of variable proportions states that, an increase in some inputs relative to other fixed inputs, in a given state of technology, cause output to increase; but after a certain point, the extra output resulting from the same additions of extra inputs will become less and less. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

MULTIPLE CHOICE QUESTIONS 1. In short run production function, one or more inputs are: 29 (a) Increasing (b) Variable (c) Constant (d) Fixed 2. An iso-quant is also called : (a) Variable product curve (b) Equal product curve (c) Horizontal contribution curve (d) None of the above 3. Iso-quant are : (a) Convex to the origin (b) Intersection curves (c) Vertical curves (d) None of the above 4. Production refers to (a) Transformation of inputs into outputs (b) Transformation of labour into capital (c) Transformation of capital into profit (d) All of the above 5. Knowledge of production function helps the manager in deciding (a) Wages (b) Marshal’s (c) Production planning (d) Bank loans Answers 1. (d), 2. (b), 3. (a) 4 (a) 5 (c) www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

FREQUENTLY ASKED QUESTIONS 30 Q1. Define Law of Variable Proportions. Ans: The law of variable proportions is defined as follows, ‘As the quantity of one input is increased, keeping the quantity of other inputs fixed, the output increase in the beginning and afterwards decreases.’ For further detail please Refer to SLM. Q2. What is Isoquant Curves. Ans: An iso-quant is the locus of all the combinations of two factors of production that yield the same level of output. For further detail please Refer to SLM. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

REFERENCES 31 1. Salvatore.(2012).Managerial Economics: Principles and Worldwide Applications. Oxford: Oxford Press. 2. Ahuja, H. L.(2017).Managerial Economics, New Delhi: S. Chand. 3. Dwivedi, D.N.(2018).Managerial Economics, New Delhi: Vikas Publications. 4. Peterson, L., Jain.(2005). Managerial Economic. New Delhi: Prentice Hall of India. 5. Mote, V.L., Gupta G..S.(2017).Managerial Economics. New Delhi: McGraw Hill Education. www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL

32 THANK YOU For queries Email: [email protected] www.cuidol.in Unit-5 (MBA601) All right are reserved with CU-IDOL