THEORY OF PRODUCTION

By:ABHIJEET DAS (030) SAHIB SARNA (041) NAINA TULI(024) DEEPTI CHHIKARA(053) MBA (FM)

INTRODUCTION
Whatever be the objective of business firms, achieving optimum efficiency in production or minimizing the cost of production is one of the prime concerns of managers today. Infact, the very survival of the firms in a competitive market depend on their ability to produce at a competitive cost.

In their effort to minimize the cost of production, the fundamental questions which managers are faced with, are:How are the Production and Costs related ? Does substitution between the factors affects the Cost of Production? How does the technology i.e., factor combination matters in reducing the cost of production ? How can the least cost combination of inputs be achieved ? What happens to rate of return when more plants are added to the firm ? What are the factors which create economies and diseconomies for the firm ?

The theory of production provide answers to these questions by providing tools and techniques to analyze the production conditions and to provide solution to the practical business problems.

SOME BASIC CONCEPTS

Production:

Production means transforming inputs ( Labour, Machines, Raw materials etc.) into an output.

Input and Output:

An input is a good or service that goes into the process of production. Land, Labour, Capital, Management, Entrepreneur and Technology are classified as inputs. An output is any good or service that comes out of the production process.

Fixed Inputs & Variable Inputs:

Fixed inputs remains fixed (constant) up to certain level of output. Variable inputs change with the change in output.

Short Run and Long Run:

Short run refers to a period of time in which supply of certain inputs i.e., plant, building and machinery etc. is fixed or inelastic. Long run refers to a time period in which the supply of all the inputs is elastic or variable.

PRODUCTION THEORY
The production theory basically addresses itself to the question: If you have fixed amount of inputs, how much output can you get ? The state of technology and engineering knowledge is assumed to remain constant. The production function specifies the maximum output that can be produced with a given quantity of inputs. It is defined for a given state of engineering and technical knowledge.

TOTAL, AVERAGE AND MARGINAL PRODUCT

Total, Average and Marginal Product Total product is the total amount of output produced in physical units like bushels of wheat or quintals of rice. Average product equals the total output divided by total units of input. Marginal (or extra) product of an input is the extra output produced by one additional unit of that input while other inputs are held constant.

PRODUCTION FUNCTION
Production function is defined as the functional relationship between physical inputs ( i.e., factors of production ) and physical outputs, i.e., the quantity of goods produced. Production function may be expressed as under: Q = f ( K,L) Where ; Q = Output of commodity per unit of time. K = Capital. L = Labour. f = Functional Relationship.

Production function depends on :

Quantities of recourses used. State of technical knowledge. Possible process. Size of firms. Relative prices of factors of production. Combination of factors.

The following points may be emphasized: Production function represents a purely technical relationship. Output is the result of joint use of factors of production. Combination of factors depend on the state of technical knowledge. Every management has to make choice of the production function which gives average cost and maximum average profit.

LAWS OF PRODUCTION
Laws of production are of two types:

The law of variable proportions. Laws of returns to scale.

THE LAW OF VARIABLE PROPORTION

Short Run Production Function: The Law of Variable Proportions Statement of the law:
The law of variable proportions states that when more and more units of the variable factor are added to a given quantity of fixed factors, the total product may initially increase at an increasing rate reach the maximum and then decline.

Tabular Presentation of Law of Variable Proportions

Units of Labour

TP

MP

AP

1 2 3

80 170 270

80 90 100

80 85 90
I Stage

4
5 6 7

368
430 480 505

98
62 50 24

92
86 80 72
II Stage

8
9 10

505
495 470

0
-9 -25

63
III Stage

55 47

Diagrammatical Presentation of Law of Variable Proportions

AP AP

Assumptions of the law: State of Technology remains the same. Input prices remain unchanged, Variable factors are homogeneous.

MP MP

Law of Diminishing Returns and Business Decisions

A Rational producer will never choose to produce in stage III where Marginal Productivity of variable factor is negative. It will stop at the end of the second stage where Marginal Productivity of the variable factor is Zero. At this point the producer is maximizing the total output and will thus be making the maximum use of the available variable factors. A producer will also not choose to produce in Stage I where he will not be making full use of the available resources as the average product of the variable factor continues to increase in this stage. A producer will like to produce in the second stage. At this stage Marginal and Average Product of the variable factor falls but the Total Product of the variable factor is maximum at the end of this stage. Thus stage II represents the stage of rational producer decision.

The Returns to scale

The long run production function is termed as returns to scale. In the long run, the output can be increased by increasing all the factors in the same proportions. The laws of returns to scale is explained by the help of Isoquant curves. An Isoquant curve is the locus of points representing various combination of two inputs, Capital & Labour, yielding the same output. There are three technical possibilities; a) Total output may increase more than proportionately: Increasing returns to scale, b) Total output may increase at a constant rate: Constant Returns to Scale, c) Total output may increase less than proportionately: Diminishing returns to scale.

Three Stages of Law of Diminishing Returns

Marginal Product

Constant Returns Increasing Returns

Diminishing Returns

Scale of Inputs

a) Increasing Returns to Scale:

C A P I T A L

Causes:

Indivisibilities of Factors, High degree of specialization,

Labour

b) Constant Returns to Scale

C A P I T A L

Causes: Factors of production fully utilized. Technology remains unchanged

c) Diminishing Returns to Scale

C A P I T A L

Causes: Managerial Diseconomies. Scarce and Exhaustible resources.

Labour

ISOQUANTS
DEFINITION AND MEANING
The word 'iso' is of Greek origin and means equal or same and 'quant' means quantity. An isoquant may be defined as: "A curve showing all the various combinations of two factors that can produce a given level of output. The isoquant shows the whole range of alternative ways of producing the same level of output". The modern economists are using isoquant, or "ISO" product curves for determining the optimum factor combination to produce certain units of a commodity at the least cost.

Isoquant is one way of presenting the production function where two factors of production are shown. It represents all possible input combinations of the two factors, which are capable of producing the same level of output. Isoquants show combinations of two inputs that can produce the same level of output. Isoquants are downward sloping because, as one factor is removed and we move down one axis, more of another factor must be added to maintain the old level of output moving up the other axis. They are convex to the origin, because increasing amounts of a second factor are required to compensate for unit decreases in the first (MRTS). Firms will only use combinations of two inputs that are in the economic region of production, which is defined by the portion of each isoquant that is negatively sloped.

An isoquant shows the extent to which the firm in question has the ability to substitute between the two different inputs at will in order to produce the same level of output. An isoquant map can also indicate decreasing or increasing returns to scale based on increasing or decreasing distances between the isoquant pairs of fixed output increment, as output increases. If the distance between those isoquants increases as output increases, the firm's production function is exhibiting decreasing returns to scale; doubling both inputs will result in placement on an isoquant with less than double the output of the previous isoquant. Conversely, if the distance is decreasing as output increases, the firm is experiencing increasing returns to scale; doubling both inputs results in placement on an isoquant with more than twice the output of the original isoquant.

OPTIMAL COMBINATION OF INPUTS

One of the most important decisions a firm has to make involves the determination of the optimal combination of factors of production. This is because this is essential for the firm to reach the profit maximising point where marginal cost equals to marginal revenue. In order to reach this point, especially if the firm operates in a perfectly competitive market it has to produce where its factors of production cost as little as possible and produce as more as possible. In other words it has to minimise costs while maximising output.

A manager who wishes to maximize profit must first decide how much output to produce and then how to produce that amount at the lowest possible total cost. When a manager wishes to produce a given level of output at the lowest possible total cost, the manager chooses the combination on the desired isoquant that costs at least. While managers whose goal is profit maximization are generally and primarily concerned with searching for the least-cost combination of inputs to produce a profit-maximizing output, managers of nonprofit organization may face an alternative situation. Whether the manager is searching for the input combination that minimizes cost for given level of production or maximizes total production for a given level of expenditure on resources, the optimal combination of inputs to employ is found using the same rule.

The General Motors Corporation has a worldwide physical capital stock valued at $70billion. Consider this to be the fixed input for the firm. About 7,60,000 workers are employed to use this capital stock. What principles guide the decisions about the level of employment? In general, to maximize profit, the firm should hire labour as long as the additional revenue associated with hiring of another unit of labour exceeds the cost of employing that unit. For example, suppose that the marginal product of an additional worker is two units of output and each unit of output is worth $20,000. Thus the additional revenue to the firm will be $40,000 if the worker is hired. If the additional cost of a worker is $30,000, that worker will be hired because $10,000, the difference between additional revenue and additional cost, will be added to profit. However, if the wage arte is$45,000, the worker should not be hired because profit would be reduced by $5,000.

Firms will only use combinations of two inputs that are in the economic region of production, which is defined by the portion of each isoquant that is negative sloped.

The isoquant is a physical relationship that denotes different ways to produce a given rate of output. The next step toward determining the optimal combination of capital and labour is to add information on the cost of those inputs. This cost information is introduced by a function called a production isocost
Isocost lines represent all combinations of two inputs that a firm can purchases with the same total cost. Given the per unit prices of capital (r) and labour (w), the total expenditure (c) on capital and labour input is C = wL + rK w= wage rate of labour r= cost of capital

For e.g.., if r=3 and w= 2, the combination of 10 units of capital and 5 units of labour will cost $40 i.e. 40 = 3(10) + 2(5). For any given cost C, the isocost lines defines all combinations of capital and labour that can be purchased for C. Solving for K as a function of L, K = c/r w/r)L Changes in the budget amount cause the isocost line to shift in a parallel manner. Changes in either the price of capital or labour cause both the slope and one intercept of the isocost function to change. When both capital and labour are variable, determining the optimal input rates of capital and labour requires that the technical information from the production function (i.e. the isoquants) be combined with the market data on input prices (i.e. the isocost functions)

At the tangency of the isoquant ans isocost, the slopes of the two functions are equal. Thus, the marginal rate of technical substitution (i.e. the slope of the isoquants) equals the price of labour divided by the price of capital. That is, MRTS = w/r The above identity is a necessary condition for efficient production.
These principles can be used to test for efficient resource allocation in production. The slope of the isocost is negative of the ratio of the wage rate and price of capital (i.e. w/r) and that the slope of the isoquant is the negative of the ratio of the marginal product of labour to that of capital (i.e. MPL/ MPk). Further, at the point of tangency, the slopes of both isocost and isoquant are equal. Thus, MPL/ MPk = -w/r MPL/ MPk = w/r Or MPL/w = MPk/r

APPLICATIONS IN MANAGERIAL DECISION MAKING

Managers make production decisions in two different decision-making time frames: SHORT-RUN PRODUCTION DECISIONS AND LONG-RUN PRODUCTION DECISIONS.
In a typical short-run situation, the manager has a fixed amount of plant and equipment within which he is supposed to produce the firms output. The manger can change production levels by hiring more or less labour and purchasing more or less rawmaterials but the size of the plant is unchangeable or fixed for the purposes of making production decisions in the short-run. Long-run decision-making concerns the same types of decisions as the short-run with one important distinction: The usage of all inputs can be either increased or decreased. In the long-run, a manager can choose to operate in any size plant with any amount of capital equipment.

SHORT-RUN COSTS OF PRODUCTION

The monetary payments to hire, rent or lease resources owned by others represent the explicit opportunity cost of using market supplied inputs. Implicit costs are the costs of using any resources the firm owns.

Fixed and variable cost

In the short run some inputs are fixed. Since these inputs have to be paid for regardless of the level of output produced, payments for fixed inputs remain constant no matter what level of output is produced. Such payments are called fixed cost. Payments for variable inputs are called variable cost. Producing more output requires more variable inputs. Thus variable costs increases as the level of output increases.

Short-run total cost

In the short-run, the levels of use of some inputs are fixed, and the costs associated with these fixed inputs must be paid regardless of the level of output produced. Other costs vary with the level of output. Total fixed cost (TFC) is the sum of the short-run fixed costs that must be paid regardless of the level of output produced. Total variable cost (TVC) is the sum of the amounts spent for each of the variable inputs used. Total variable cost increases as output increases. Short run Total cost (TC), which also increases as output increases, is the sum of total variable and total fixed cost: TC = TVC + TFC

SHORT-RUN COSTS OF PRODUCTION

The time periods that we use in Economics can sometimes appear arbitrary they help to provide a framework within which we can analyze the behavior of businesses in different markets and industries but the length of time that constitutes the short run clearly varies across industries and the reality is that most businesses can vary the amount of capital input in the short run by leasing items of machinery and renting additional commercial property and factory space if it is available.

In the long run, an industry and the individual firms it comprises can undertake all desired resource adjustments or in other words, they can change the amount of all inputs used. The long run allows sufficient time for new firms to enter or for existing firms to leave an industry. Period of time long enough for firms to change the quantities of all resources employed including capital and new factories. In the long run, there is no distinction between FC and VC because all resources (therefore costs) are variable in the long run

Economies And Diseconomies of Scale

5 Types Of Economies of Scale1. Managerial Economies of scale: The ability of a business to outsource and hire new people depending on its size. 2. Technological: The ability of a business to require new capital 3. Marketing: The ability of a business to get discounts for supplies 4. Financial: The ability to get loans from banks or use assets in order to purchase more technology 5. Risk Bearing: The ability of a company to diversify.

Diseconomies of Scale: This is an increase in ATC as output increases. This is usually attributed to the difficulty of efficiently controlling and coordinating a firm's operations as it becomes a large-scale producer. Overexpansion of management leads to: Bureaucratic red tape Miscommunication Slower decision-making Lower action in the face of changes in consumer tastes or technology

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