MBA-CM_ME_Lecture 9 Production

7/30/2019 MBA-CM_ME_Lecture 9 Production

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Dipankar De

Mumbai, August 2007

Narsee Monjee Institute of Management StudiesNMIMS University

Theory of Production


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The Firm

A firm is an organisation, owned by one or jointly by a few or many

individuals which is engaged in productive activity of any kind for the

sake of profit or some other well-defined aim.


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Production Function

The relationship between the volume of physical inputs into production and the

number of units of output produced is known in economics as the production

function. It describes the technological relation:

q = quantity of output of good

f(*) summarises the rate at which conversion of inputs into output takes place,

everything being expressed as rates per period of time.

Simplifying,

where q = quantity of output per period of time

L = labour hours per period employed

K = units of capital services (machine hours)

),....,,,,( nxxxxxfq 4321

),( KLfq


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Production Function

There are different types of production function that has been empirically testedand found their relevance. These are:

1. Cobb-Douglas production function

2. Constant Elasticity of Substitution (CES) production function

3. Trans Log production function

The Cobb-Douglas production function is the most popular among these,mainly because of various important properties that it exhibits and its simpler

form. It can be expressed as:

constants, where A is the technological specification

The production function defined above is technologically determined

physical relationship which puts outside influences on economic

analysis.

A firm cannot go out of the technological alternatives specified by the

production function, but the one that it chooses is a matter of economic

consideration, mainly determined by factor prices.

,

KALq

,


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Short run and Long run

Short Run (SR)

The short run is defined as the period of time over which some inputs (at least

one input), called fixed input, cannot be varied. E.g. capital plant & equipment,

land, services of management or supply of skilled labour, etc. This is not of fixed

duration in all industries and is influenced by technological considerations.

The Long Run (LR)

The long run is defined as the period long enough for all inputs to be varied, but

not so long enough that the basic technology of production changes.

This is not of specified period of time it varies; e.g. planning to go into

business, or to expand/ contract the scale of operations.

The Very Long Run

It is concerned with situations in which technological possibilities open to the

firm are subject to change, leading to new and improved products and new

methods of production, e.g. changes through R&D, etc.


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Variable and Fixed Factor

A variablefactoris one whose quantity can be changed in a

relatively short period of time;

While the fixed factors are held constant during this period.

E.g. factory size is fixed in short period, and labour, electricity are

variable.


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Average & Marginal Product


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Relation between AP and MP

Total product initially increases until it reaches the maximum; thereafter

it diminishes. Marginal product is always positive when output is

increasing and negative when output is decreasing.

When the marginal product is greater than the average product, the

average is increasing.

Similarly, when the marginal product is less than the average product,

the average product is decreasing.

Because the MP is above the AP when the average product is

increasing and below the average product when the AP is decreasing,

it follows that the MP must equal the AP when the average product

reaches its maximum.


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E

MP=0

Marginal

Product

C

B

A

APmax

MPmax

Total Product

TPmaxTP

AP,

MP

Labour

permonth

Average

Product

Labour

permonth

Production with One Variable Input


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Law of Diminishing Returns

The law states that if increasing quantities of a variable input are applied to

a given quantity of a fixed input, the marginal product and the average

product of the variable input will eventually decrease.

This law applies to a given production technology. Overtime, however,

inventions and other improvements in technology may allow the entire total

product curve to shift upward, so that more output can be produced with

same inputs.


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Concept of Isoquant

An Isoquant is a curve that shows all

the possible combinations of inputs

that yield the same output. Each

Isoquant is associated with a

specific level of output.

An Isoquant map is a set of

isoquants, each of which shows the

maximum output that can be

achieved for any set of inputs. An

Isoquant map is a way of describing

a production function. The level of

output increases as we move up and

to the right of the Isoquant-map.

(L1,

K1)

(L2,K2)

Labour

K1

K2

L1 L2

Isoquant

Q1


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Concept of Isoquant

With two inputs that can be varied, a manager would want to consider

substituting one input of the other.

The slope of the Isoquant indicates how the quantity of one input can be

traded off against the quantity of the other, while keeping the output constant.

When the negative sign is removed, the slope is called the Marginal Rate of

Technical Substitution (MRTS).

The Marginal Technical Rate of Substitution is the amount by which the input

of capital can be reduced when on extra unit of labour is used, so that outputremains constant. .

output)oflevelfixedafor(inputlabourinChange

inputcapitalinChange

L

KMRTS


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Elasticity of Substitution

This shows the ease with which capital and labour or any other set of inputs

can be substituted for each other.

In some cases, it may be possible to combine capital and labour in different

proportions for production of a given level of output, while in some other

cases it may not.

The property of elasticity of substitution indicates such possibilities.

Elasticity of substitution varies from zero to infinity. For fixed-proportions PF,

it is zero. For perfect substitutes, it is infinity; while for Cobb-Douglas PF, it

may be unitary. For CES PF elasticity of substitution remains constant, but

not necessarily unity.


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Elasticity of Substitution: SpecialCases

Labour

Shovel

Red Pen

BluePen

Fixed-Proportions PF Perfect Substitutes Inputs PF


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Concept of Returns to Scale

To answer the question:How does the outpu t change as i ts inpu ts are

propor t ionatelyincreased? -we need the concept of returns to scale.

It refers to the way that output changes as we change the scale of production. It

is essentially a long-run concept.

If we scale all the inputs by some amount t and output goes up by the same

factor, then we have constant returns to scale.

If output scales up by more than t, we have increasing returns to scale; and

If it scales up by less than t, we have deceasing returns to scale.


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Significance Returns to Scale

Returns to scale vary considerably across firms and industries. Other

things being equal, the greater the returns to scale, the larger firms in an

industry are likely to be.

Manufacturing industries are likely to have increasing returns to scale

than service-oriented industries because manufacturing involves large

investments in capital equipment.

Services are labour intensive and can usually be provided as efficiently

in small quantities as they can on a large scale.

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MBA-CM_ME_Lecture 9 Production