MEA Unit 3 Production Function

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Theory Of Production

Unit : IIIManagerial Economics & Accounting

3rd Sem IT

Presented By : Yashwant Misale (BE ,MMS)

Faculty MBA Department DMIETR



Theory of Production

Production: Basic concept

Transformation of input into output

Creation of utility

Act of creation of utility by transforming the Input (land, labor, capital and raw

material) into output through organizing and combining the productive resources.

Production is related to:

Physical change of the objects and Services that satisfies the intangible needs of

human being.

Therefore the scope of the term production covers the manufacturing activities

like Rice, cloth and cars as well as the services like banking, transportation, media

etc.

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Factors of Production

Hundreds and thousands of factors can be used, They can be

classified under 4 broad generic factors

Land

Labor

Capital

Entrepreneurship





LAND

It means all the natural resources, which yields income or which has

exchange value. In the other word, it refers to all the natural resources,

which is used in production.Land ± Features

Land is free gift of nature

It has fixed quantity of supply

It is permanent in nature

Lack of geographical mobility

Infinite variety





LABOR

Any ³Human Effort´ involved in the production function in exchange

of money.

Labor- Features

Inseparable from laborer

Has to be sold in person

Doesn¶t last long

Late adjustment in supply as a result of change in price





CAPITAL

It is that part of the produced elements that is further used in

production instead of being consumed directly

Capital ± features

Capital is produced element

Capital has certain longevity

It is mobile

Amount capital can be increased through human effort

Income from capital is uniformed if it is used with same degree of

efficiency





ENTR EPR ENEURSHIP

Human element that initiates and directs the production process by

combining the productive resources. Entrepreneur is responsible for

whole production processEntrepreneurship ± features

Decision Maker

Brings the productive resources together

Risk taker

Innovator




8

The Firm

A firm is an organisation, owned by one or jointly by a few or manyindividuals which is engaged in productive activity of any kind for the sake

of profit or some other well-defined aim.




10

Production Function

There are different types of production function that has been empirically tested and

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.

, FE K AL q !

FE ,




11

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. 9/15/2010MEA : Yashwant Misale



12

Variable and Fixed Factor

A variable factor is 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.




13

Average & Marginal Product




E

MP=0

Marginal

Product

C

B

A

APmax

MPmax

Total

Product

TPmaxTP

AP,

MP

Labour per

month

Average

Product

Labour

per

month

Production with One Variable Input

9/15/2010 15MEA : Yashwant Misale



16

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.




17

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,

K 1)

(L2,K 2)

Labour

K 1

K 2

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 output remainsconstant. .

output )of levelfixedafor (input labour inChange

input capit alinChange

L MRTS

(

(!!




19

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.




20

Elasticity of Substitution: SpecialCases

Labour

Shovel

Red Pen

BluePen

Fixed-Proportions PF Perfect Substitutes Inputs PF




21

Concept of Returns to Scale

To answer the question: ³How does the output change as its inputs are

proportionately increased?´ - 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 µt¶ and output goes up by the same factor, then

we have constant returns to scale.

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

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




22

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.




Break Even Analysis




Break Even Analysis

The Break-even Point is, in general, the point at which the gains equal the losses.

A break-even point defines when an investment will generate a positive return.

The point where sales or revenues equal expenses. Or also the point where total costs equal

total revenues.

There is no profit made or loss incurred at the break-even point. This is important for anyonethat manages a business, since the break-even point is the lower limit of profit when pricesare set and margins are determined.

Achieving Break-even today does not return the losses occurred in the past. Also it does not build up a reserve for future losses. And finally it does not provide a return on your investment (the reward for exposure to risk).

The Break-even method can be applied to a product, an investment, or the entire company'soperations




THE RELATIONSHIP BETWEEN FIXEDCOSTS, VARIABLE COSTS AND RETURNS

Break-even analysis is a useful tool to study the relationship between fixed costs,variable costs and returns.

The Break-even Point defines when an investment will generate a positive return. Itcan be viewed graphically or with simple mathematics.

Break-even analysis calculates the volume of production at a given price necessary tocover all costs. Break-even price analysis calculates the price necessary at a givenlevel of production to cover all costs. To explain how break-even analysis works, it isnecessary to define the cost items.

Fixed costs: Costs which are incurred after the decision to enter into a businessactivity is made, are not directly related to the level of production. Fixed costs include, but are not limited to, depreciation on equipment, interest costs, taxes and generaloverhead expenses. Total fixed costs are the sum of the fixed costs.

Variable costs: Costs which change in direct relation to volume of output. They may

include cost of goods sold or production expenses, such as labor and electricity costs,fuel, irrigation and other expenses directly related to the production of a commodity or investment in a capital asset.

Total variable costs : (TVC) are the sum of the variable costs for the specified levelof production or output.

Average variable costs :(AVC) are the variable costs per unit of output or of TVCdivided by units of output.




BREAK-EVEN POINT CALCULATION

Calculation of the BEP can be done using the following formula:

BEP = TFC / (SUP - VCUP)

where:

BEP = break-even point (units of production)

TFC = total fixed costs,

VCUP = variable costs per unit of production,

SUP = selling price per unit of production.

BENEFITS OF BR EAK -EVEN ANALYSIS

The main advantage of break-even analysis is that it explains the relationship between cost, production volumeand returns.

Break-even analysis is most useful when used with partial budgeting or capital budgeting techniques.

The major benefit to using break-even analysis is that it indicates the lowest amount of business activitynecessary to prevent losses.

LIMITATIONS OF BR EAK -EVEN ANALYSIS

It is best suited to the analysis of one product at a time;

It may be difficult to classify a cost as all variable or all fixed; and

There may be a tendency to continue to use a break-even analysis after the cost and income functions havechanged.




27

Concepts of Cost

Given a firm¶s production technology, managers must decide µhow¶ to produce. As the inputs

can be combined in various ways to yield the same amount of output, we are interested in

how the µoptimal¶ (cost-minimising) combination of inputs is chosen, given the factor prices.

There are differences with the concept of cost between the economists and the accountants,

who are concerned with the firm¶s financial statements.

Accounting cost includes depreciation expenses for capital equipment, which are determined

on the basis of the allowable tax treatment according to the Taxation Rules of the country.

Economists are concerned with what cost is expected to be in the future, and with how the

firm might be able to rearrange its resources to lower its cost and improve profitability. Thus,

they are concerned with ³opportunity cost´.




28

Cost in the Short Run

Total cost of production has two components:

± Fixed cost, FC, which is borne by the firm whatever level of output it produces,

± Variable cost, VC, which varies with the level of output.

Depending upon the circumstances, FC may include expenditures for plant

maintenance, insurance, and perhaps a minimal no. of employees ± this cost

remains same no matter how much the firm produces.

Fixed cost must be paid even if there is no output.

Variable cost includes expenditures for wages, salaries, and raw materials ±

this cost increases as output increases.




29


Marginal cost (MC)

It is the increase in cost that results from producing one extra unit of

output. Because FC does not change as the firm¶s level of output changes,

MC is just the increase in variable cost that results from an extra unit of output.

MC tells us how much it will cost to expand the firm¶s output by one unit.

Q

VC M C

(

(!




30


Average cost (AC)

Average cost is the cost per unit of output. Average Total cost (ATC) is the

firm¶s total cost divided by its level of output. ATC has two components:

± Average Fixed Cost ± AFC is the fixed cost divided by the level of output

± Average Variable Cost ± AVC is variable cost divided by the level of output

A VC AF C A T C

Q

VC

Q

F C

Q

T C

VC F C T C

!

!

!




31

Shapes of Cost Curves in the ShortRun

Quantity

Cost

Total Cost

Total Variable Cost

Total Fixed Cost

Variable and total costs increase with output. The rate at which these costs increase depends on the

nature of the production process, and in particular on the extent to which production involves

diminishing returns to variable factors.




32

AFC

Quantity

AFC

Quantity

Average Product

AP

Average Cost

AC

Shapes of Cost Curves in the ShortRun




33

Quantity

AverageVariable Cost

Marginal Cost

MC, AVC

Relation between Cost Curvesin the Short Run

Whenever marginal cost lies below average cost, the AVC curve falls. Whenever MC

lies above average cost, the AVC curve rises. And when average cost is at a minimum,

MC curve equals average cost.




34

Relation between Cost Curves in theShort Run

Average Total Cost

MC, AV

CATC

Quantity

Average Variable Cost

Marginal Cost

Since the difference between ATC and AVC is the AFC, which continuously declines as output

increases, the gap between ATC and AVC curves narrows further; however AVC & ATC curves

never meet as AFC never becomes zero. The MC curve passes through the minimum points of

both ATC and AVC curves




35

Knowledge of short-run costs is particularly important for firms that

operate in an environment in which demand conditions fluctuate

considerably. If the firm is currently producing at a level of output at

which MC is sharply increasing, and demand may increase in future,

the firm might consider expanding its production capacity to avoid

higher costs.

Relation between Cost Curves in theShort Run




36

Long-run Average Cost

The most important determinant of the shape of the long-run average and marginal cost

curves is whether there are increasing, constant, or decreasing returns to scale.

If the firm¶s production process exhibits constant returns to scale at all levels of output,

then a doubling of inputs leads to a doubling of output. Because input prices remain

unchanged as output increases, the average cost of production must be same for all

levels of output.

If the firm¶s production process exhibits increasing returns to scale at all levels of

output, then a doubling of inputs leads to more than doubling of output. Then the

average cost of production falls with output because a doubling of costs is associated

with more than two-fold increase in output.




37

Long-run Average Cost

In the long-run, most firms¶ production technology first exhibit

increasing returns to scale, then constant returns to scale, and

eventually decreasing returns to scale.




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Shape of Long-run Average Cost

Economists think that the LRAC is U-shaped mainly because of:

± Downward falling section is due to Economies of Scale

± Flat section ± mainly due to constant returns to scale

± Upward rising section of LRAC is due to Diseconomies of Scale




39

Long-run Marginal Cost

LRMC measures the change in long-run total costs as output is increased

incrementally. LMC lies below the LRAC curve when long-run average cost is falling;

and above the LRAC curve when long-run average cost is increasing.

The two curves intersect where the LRAC curve achieves its minimum.




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Long-run Marginal Cost

Q* is the optimal plant size/ scale. At this level of output, SRAC is also at its

minimum, and hence is said to operate at the optimum level of output. Any

level of output below or above would exhibit below capacity or above capacity.


MEA Unit 3 Production Function

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