LONG RUN PRODUCTION FUNCTION

MBA (PM)
What Is Production
Function
Production function deals with the
maximum output that can be
produced with a limited and
given quantity of inputs.

 PRODUCTION FUNCTION

1.The tool of analysis used to explain the input-

output relationship
2.Describes the technological relationship
between inputs and outputs in physical terms
3.It tells that the production of a commodity
depends on specific inputs
4.It represents quantitative relationship between
inputs and output
5.It represents the technology of a firm, of an
industry, or of the economy as a whole
Production Function
Mathematical representation
of the relationship:
Q = f (K, L, La)
Output (Q) is dependent upon
the amount of capital (K), Land
(L) and Labour (La) used

 ASSUMPTIONS

THE PRODUCTION FUNCTIONS ARE BASED ON

CERTAIN ASSUMPTIONS
1. Perfect divisibility of both inputs
and outputs
2. Limited substitution of one factor
for another
3. Constant technology
4. Inelastic supply of fixed factors in
the short run
 THE LAWS OF PRODUCTION

LAWS OF VARIABLE LAWS OF RETURNS

PROPORTIONS TO SCALE

Relates to the study Relates to the study

of input output of input output
relationship in the relationship in the
short run with one long run assuming
variable input while all inputs to be
other inputs are variable
held constant
What is long run production
function ?
 Long run refers to that time in the
future when all inputs are variable
inputs.

 In the long run both capital and
labour are included


 Output can be varied by changing

the levels of both L & K and the
long run production function is
expressed as:

THE LAW OF RETURNS TO SCALE

EXPLAINED BY

ISOQUANT PRODUCTION
CURVE
TECHNIQUE FUNCTION
LONG RUN TOTAL PRODUCTION-
Returns to scale

 During the short period, some factors of
production are relatively scarce, therefore ,
the proportion of the factors may be
changed but not their scale. But in the long
run, all factors are variable, therefore, the
scale of production can be changed in the
long run

 Returns to scale is a factor that is studied in
the long run.

Returns to Scale
When all inputs are changed in the
same proportion (or scale of
production is changed),the total
product may respond in three
possible ways:
1)Increasing returns to scale
2)Constant returns to scale, and
3)Diminishing returns to scale
INCREASING RETURNS TO SCALE
 The law of increasing
returns to scale operates
when the percentage
increase in the total
product is more than the
percentage increase in all
the factor inputs employed
in the same proportion.
 Many economies set in and
increase in return is more
than increase in factors.
 For e.g 10 percent increase
in labour and capital
causes 20 percent
increase in total output.
Similarly, 20 percent
increase in labour and
CONSTANT RETURNS TO SCALE
 Law of constant
returns to scale
operates when a
given percentage
increase in the
factor inputs in the
same proportion
causes equal
percentage
increase in total
output.


 Economies of scale
are counter
balanced by
diseconomies of
DIMINISHING RETURNS TO
SCALE
The law of
diminishing
returns to scale
occurs when a
given percentage
increase in all
factor inputs in
equal proportion
causes less than
percentage
increase in output.


Outputincreases in a
smaller
Graphically , the returns to scale
concept can be illustrated using
the following graphs

DRTS
CRTS Q
IRTS Q
Q

X,Y X,Y X,Y

ADVANTAGES AND DISADVANTAGES OF LARGE SCALE PRODUCTION

Specialization Rent

Economy of Overhead
labour charges

Economics of
buying and
selling
Reduction in costs when the
scale of production
increases is called

ECONOMIES OF
SCALE

INTERNAL EXTERNAL
ECONOMIES ECONOMIES
 INTERNAL ECONOMIES

Technologic Large scale production

provides opportunities for
al technological advances
Economies Advantages
in
Production Large scale production
Advantages of workers of varying skills &
qualifications are employed
which facilitates division
divisions of of labour as per
specialization
labour
.. Large scale
selling& of firms
own products
Specialization
.. Large scale
purchase of raw Improves the overall
Economies materials & other performance of the
in inputs firm
Marketing .. Advertising
cost

.. Large
scale
distribution
 .. Specialization
in managerial
activities
Managerial .. Improves
Economies managerial
.. Mechanization efficiency
of managerial
functions

.. Efficient
management of the
transport
function .. Helps in
Transport reducing
transportation
& and storage costs
Storage
Economies
.. Proper
utilization of
storage
facilities
 CAUSES OF INTERNAL ECONOMIES

Bigger capacity
Big lower Energy
SIZE Machine less labou

LIMITING Mergers
Spreading of
costs
PROCESS

Superior Shorter period

TECHNIQUE Technique of time

SPECIALI - Division of
Labour
Increase in
efficiency

ZATION
MANAGERIAL Managerial
ECONOMICS Aggregation economies

Financial
economies Credit facilities

COMMERCIAL
ECONOMIES

Wide Market Encourages

investment

RISK BEARING
ECONOMIES Diversification Spreading
Risks
 CAUSES OF EXTERNAL ECONOMIES
Common Pool of
Knowledge
Advantage
CONCENTRATION s of locality
Reduced
transportation cost
of
locality The benefits which
companies derive
from trade
Knowledge publications and
INFORMATION sharing technical journals
By virtue of
location , common
pool of research
can be created and
benefits can be
shared
Breaking up of
Breaking processes which can
DISINTEGRATION up be handled by
specialist firms
 Production Isoquants /
isoquant curve / iso - product
curve
In the long run, all inputs are
variable & isoquants are used to
study production decisions
–An isoquant or iso-product curve is a
curve showing all possible input
combinations capable of producing a
given level of output
–Isoquants are downward sloping; if
greater amounts of labor are used,
less capital is required to produce
a given output

22
ASSUMPTIONS


1.THERE ARE ONLY TWO FACTORS

OF PRODUCTION…CAPITAL (K)
AND LABOUR (L) TO PRODUCE
A COMMODITY X
2.THE TWO FACTORS CAN
SUBSTITUTE EACH OTHER UP
TO A CERTAIN LIMIT
3.THE TECHNOLOGY IS GIVEN
OVER A PERIOD

 Example Isoquant
Curve
The following
combinations of 7
Units of capital
inputs X and Y 6
produce 100 Isoquant; TP = 100 units
units of output: 5
º2,6 4
º3,4 Units of Y
º4,3
3
º6,2 2
º8,2
1
0 Units of Labour

0 2 4 6 8
 Isoquant curve for 100
units of output
PROPERTIES:-
1.Slopes downward towards
right
2.Convex to the origin point
because of diminishing
marginal rate of technical
substitution (MRTS)
change in capital
A MRTS =
K4 change in labour
B 3. Two iso-product curves do
K3 not cut each other
Units of K

K2 C

D
K1
Iq1 = 100

0
L1 L2 L3 L4

Units of L
 ISOQUANT MAP -
A family or a
group of isoquants is called an
ISOQUANT MAP

K4 A
Iq4 = 400
B
Units of K

K3
Iq3 = 300
K2 C
Iq2 = 200
D
K1

Iq1 =
100
0
L1 L2 L3
L4
Units of L
 The Isocost Line
Cost = Rs50
A a Per unit price
10 of labor input
Capital, K (machines

= Rs10/hour
b Per unit price
8 of capital
input =
c Rs5/machine
6
rented)

d
4

e
2

0 1 2 B3 4 5 6
7 8
Labor, 9 10 employed)
L (worker-hours 27
 Slope of isocost
M=P .Qline
 L +P .Q
L K K
Where, M=total outlay
 PL= price per unit of labor
 QK= price per unit of capital
 QL= units of labor
 QK= units of capital


Slope of isocost line= OA/OF



price per unit of labour input

=−


 price per unit of capital input



Slope of isocost line can be change in two ways:



1)Change in the factor price, and

2)Change in total outlay or total cost
 Price
Decrease in the factor price causes rightward
shift and increase in factor price causes
leftward shift in iso-cost line.
Capital, K (machines rented)

a Cost = 500; labor,R = 16.5 or 10or 1/ hour

10 The money wage, W = Rs5/machine

6 A Change
in unit price of labor
4

2 …Rs10
Rs16.5 h f …Rs1

0 1 2 3 4 5
6 7 L (worker-hours
Labor, 8 9 employed)
10
29
 K
Change in total outlay or total cost
Un
it Direction of increase
s in total cost

Slope = - w / r
of

TC= Rs. 100

TC= Rs. 75
ca
pi
ta
l TC=Rs. 50
(r
)
L
Units of
labour ( w )
30
 Isoquants and Cost Minimization
K
0
IQ
Un IQ 2 3
it
s
of 2
 M
IQ
Ca 1
p[
it N
 P”
al 4 
 P
TC=Rs10
0 Q=300
6 TC=Rs=75
Q=200

TC=Rs50
P’

8
Q=100
L
0 2 4 6 8 10 12 14
16 18 20
Units of
10 Labour 31
 Optimization & Cost
 Expansion path gives the
efficient (least-cost) input
combinations of labor and capital
needed foe every levels of output.
üDerived for a specific set of input
prices
üAlong expansion path, input-price ratio
is constant & equal to the marginal
rate of technical substitution
It is defined as the locus of tangency
points between iso-cost lines and
isoquants.
– 32
 EXPANSION PATH
It implies to Long run
because:
üNo input is fixed.
üPath starts from
origin indicating that
if output is zero

Capital input
costs are zero .
Expansion path gives us
the
level of output & one
least
combination that can
Labor input
produce this level of
output.
Movement along the line
gives
the costs at which output
can
ISOQUANTS AND RETURNS
TOSCALE
INCREASING RETURNS TO SCALE
0E>EE1>EE2
 CONSTANT RETURNS TO
SCALE

EE1=EE2=EE3
DIMINISHNING RETURNS TO
SCALE

0E<EE1<EE2
The LR Relationship Between

Production and Cost

 In the long run, all inputs are variable.
◦ What makes up LRAC?

Long run average cost
LRAC is made up of SRACs . Since
LR A C re fe rs to LRAC envelopes all short run
minimum possible per curves , hence Called ENVELOPE
unit cost CURVE
of producing
different quantities
of output of
a good in the long
period.
SRAC curves represent
various plant sizes
Once a plant size is
chosen, per-unit
production costs are
found by moving along
that particular SRAC
curve
 Envelope curve

LRAC can never cut SRAC but it will be

tangential to each SRAC at some point.
Average cost can not be higher in the
long run than in the short run;
Explanation;
1.Any adjustment which will reduce costs
possible to be made in the short run
must also be possible in the long run
2.It is not always possible in the short
run to produce a given output in the
cheapest possible way as all the factors
are not variable.
 Long run average cost
curve
properties
vU-shaped curve.
vBased on assumption of
unchanging technology.
vLRACMinimum efficient
is flatter scale
curve than the is the lowest output leve
SRAC.
qIn economics ,we define long
period as that during which size
of the organization can be
altered to meet changed
conditions.
vNormally;
qOutput increases and average
costs also increases
qBut in long run, size of the
firm Can be increased
therefore Variable costs are
likely to rise less sharply. Hence
a flatter curve.
The Long - Run Cost Function
Reasons for Economies of Scale…
üIncreasing returns to scale
üSpecialization in the use of labor
and capital
Economies in maintaining inventory
Discounts from bulk purchases
Lower cost of raising capital funds
Spreading promotional and R&D costs
üManagement efficiencies
The Long - Run Cost Function

Reasons for Diseconomies of Scale…

üDecreasing returns to scale
üInput market imperfections e.g. wage rate
driven up
üManagement coordination and control
üproblems
üDisproportionate rise in transportation costs
üDisproportionate rise in staff and indirect
labour
Application of the
concept
In the long run, a firm exercises its
choice
with regard to the size of the plant

and
scale of production, on the basis of

long run
average cost.

Selection of the optimal plant size

according
to the expected demand.

Avoid unnecessary costs due to