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8/8/2019 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
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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
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Factors of Production
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
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Factors of Production
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
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Factors of Production
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
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Factors of Production
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
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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.
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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 ,
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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. 9/15/2010MEA : Yashwant Misale
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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.
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Average & Marginal Product
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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
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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,
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
(
(!!
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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: 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.
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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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Break Even Analysis
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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
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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.
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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.
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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´.
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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.
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Cost in the Short Run
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
(
(!
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Cost in the Short Run
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
!
!
!
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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.
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AFC
Quantity
AFC
Quantity
Average Product
AP
Average Cost
AC
Shapes of Cost Curves in the ShortRun
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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.
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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
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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
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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.
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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
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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.
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