Theory of ProductionTheory of Production

Presented By:Presented By:

Pankaj Kumar Pankaj Kumar

RBS ; MeadowsRBS ; Meadows

IntroductionIntroduction

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

In their effort to minimize the cost of production, the In their effort to minimize the cost of production, the fundamental questions which managers are faced with, are:-fundamental questions which managers are faced with, are:-

How are the Production and Costs related ?How are the Production and Costs related ? Does substitution between the factors affects the Cost Does substitution between the factors affects the Cost

of Production?of Production? How does the technology i.e., factor combination How does the technology i.e., factor combination

matters in reducing the cost of production ?matters in reducing the cost of production ? How can the least cost combination of inputs be How can the least cost combination of inputs be

achieved ?achieved ? What happens to rate of return when more plants are What happens to rate of return when more plants are

added to the firm ?added to the firm ? What are the factors which create economies and What are the factors which create economies and

diseconomies for the firm ?diseconomies for the firm ?

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

Some Basic ConceptsSome Basic Concepts

Production:Production: Production means transforming inputs ( Labour, Machines, Raw materials etc.) Production means transforming inputs ( Labour, Machines, Raw materials etc.)

into an output.into an output.

Input and Output:Input and Output: An input is a good or service that goes into the process of production. Land, An input is a good or service that goes into the process of production. Land,

Labour, Capital, Management, Entrepreneur and Technology are classified as Labour, Capital, Management, Entrepreneur and Technology are classified as inputs.inputs.

An output is any good or service that comes out of the production process.An output is any good or service that comes out of the production process.

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

Short Run and Long RunShort Run and Long Run:: Short run refers to a period of time in which supply of certain inputs i.e., plant, 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. 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 Long run refers to a time period in which the supply of all the inputs is elastic or

variable.variable.

Production FunctionProduction Function

Production function is defined as “Production function is defined as “the functional relationship the functional relationship between physical inputs ( i.e., factors of production ) and between physical inputs ( i.e., factors of production ) and physical outputs, i.e., the quantity of goods produced”.physical outputs, i.e., the quantity of goods produced”.

Production function may be expressed as under:Production function may be expressed as under:

Q = f ( K,L)Q = f ( K,L) Where ;Where ; QQ = Output of commodity per = Output of commodity per unit of time.unit of time. KK = Capital. = Capital. LL = Labour. = Labour. f f = Functional Relationship. = Functional Relationship.

Production function depends on :Production function depends on :

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

The following points may be emphasized:The following points may be emphasized:

• Production function represents a purely Production function represents a purely technical relationship.technical relationship.

• Output is the result of joint use of factors of Output is the result of joint use of factors of production.production.

• Combination of factors depend on the state Combination of factors depend on the state of technical knowledge.of technical knowledge.

Every management has to make choice of the Every management has to make choice of the production function which gives average cost and production function which gives average cost and maximum average profit.maximum average profit.

Laws of ProductionLaws of Production

Laws of production are of two types:Laws of production are of two types:

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

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 ProportionsTabular Presentation of Law of Variable Proportions

Units of Units of LabourLabour

TPTP MPMP APAP

I StageI Stage

II StageII Stage

III StageIII Stage

11 8080 8080 8080

22 170170 9090 8585

33 270270 100100 9090

44 368368 9898 9292

55 430430 6262 8686

66 480480 5050 8080

77 505505 2424 7272

88 505505 00 6363

99 495495 -9-9 5555

1010 470470 -25-25 4747

Diagrammatical Presentation of Law of Variable Diagrammatical Presentation of Law of Variable ProportionsProportions

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

AP

MP

AP

MP

A Rational producer will never choose to produce in stage III where 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 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 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 Zero. At this point the producer is maximizing the total output and will thus be making the maximum use of the available variable factors.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 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 be making full use of the available resources as the average product of the variable factor continues to increase in this stage.the variable factor continues to increase in this stage.

A producer will like to produce in the second stage. At 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 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 Product of the variable factor is maximum at the end of this stage. Thus stage II represents the stage of rational producer decision.stage II represents the stage of rational producer decision.

Law of Diminishing Returns and Business DecisionsLaw of Diminishing Returns and Business Decisions

Long Run Production Function: The Returns to scaleLong Run Production Function: The Returns to scale

The long run production function is termed as returns to scale. In the 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 long run, the output can be increased by increasing all the factors in the same proportions.same proportions.

The laws of returns to scale is explained by the help of Isoquant curves. The laws of returns to scale is explained by the help of Isoquant curves. An Isoquant curve is the locus of points representing various An Isoquant curve is the locus of points representing various combination of two inputs, Capital & Labour, yielding the same output. combination of two inputs, Capital & Labour, yielding the same output.

There are three technical possibilities;There are three technical possibilities;a) Total output may increase more than proportionately: Increasing a) Total output may increase more than proportionately: Increasing returns to scale,returns to scale,b) Total output may increase at a constant rate: Constant Returns to b) Total output may increase at a constant rate: Constant Returns to Scale,Scale,c) Total output may increase less than proportionately: Diminishing c) Total output may increase less than proportionately: Diminishing returns returns to scale.to scale.

Three Stages of Law of Diminishing ReturnsThree Stages of Law of Diminishing Returns

Increasing ReturnsIncreasing Returns

Constant Returns

Diminishing Returns

Scale of Inputs

Ma

rgin

al P

rod

uct

ISOQUANTSISOQUANTSIsoquant is one way of presenting the production function where two Isoquant is one way of presenting the production function where two factors of production are shown.factors of production are shown.It represents all possible input combinations of the two factors, which It represents all possible input combinations of the two factors, which are capable of producing the same level of output.are capable of producing the same level of output.

IQ

O

Y

X

a

b

c

d

LABOUR

CAPITAL

ΔK

ΔL

ΔKΔL

ΔKΔL

Marginal rate of technical substitution indicates the rate at which Marginal rate of technical substitution indicates the rate at which factors can be substituted at margin in such a way that the total output factors can be substituted at margin in such a way that the total output remains unaltered.remains unaltered.

MRTS of L for K is defined as the quantity of K which can be given up MRTS of L for K is defined as the quantity of K which can be given up in exchange for an additional unit of L, so that level of output remains in exchange for an additional unit of L, so that level of output remains the same.the same.

The MRTS at a point on the isoquant can be measured by the slope of The MRTS at a point on the isoquant can be measured by the slope of isoquant at that point.isoquant at that point.

Slope of IQ at point b = Slope of IQ at point b = ΔΔK/K/ΔΔL.L.

MRTS = Slope = MRTS = Slope = ΔΔK/K/ΔΔL.L.

MRTS can be known from the ratio of MPP of two factors.MRTS can be known from the ratio of MPP of two factors.

As output remains the same at every point of isoquants so loss in As output remains the same at every point of isoquants so loss in physical output from a small reduction in K will be equal to the gain in physical output from a small reduction in K will be equal to the gain in physical output from a small increment in L.physical output from a small increment in L.

Thus,Thus,

Loss of output = Gain of outputLoss of output = Gain of output

i.e. [(Reduction in K ) X (MPP of K)] = [(Increment in L) X (MPP of L)]i.e. [(Reduction in K ) X (MPP of K)] = [(Increment in L) X (MPP of L)]

OR,OR, ΔΔK X MPK = K X MPK = ΔΔL X MPLL X MPL

ΔΔKK = = MPLMPL ΔΔL MPKL MPK

OR,OR,

MRTSLK = MRTSLK = MPL MPL ( By definition ( By definition ΔΔKK = MRTS LK = Slope of isoquant at = MRTS LK = Slope of isoquant at that point )MPK that point )MPK ΔΔLL

Thus, MRTSLK is the ratio of marginal physical productivities of the two Thus, MRTSLK is the ratio of marginal physical productivities of the two factors. factors.

Iso-Cost LinesIso-Cost Lines It shows all the combinations of the two factors ( say labour and It shows all the combinations of the two factors ( say labour and

Capital) that the firm can buy with a given set of prices of two Capital) that the firm can buy with a given set of prices of two factors.factors.

It plays an important role to determine combinations of factors, the It plays an important role to determine combinations of factors, the firms will choose for production ultimately to minimize cost. firms will choose for production ultimately to minimize cost.

OX

Y

PRICE OF LABOUR

PRICE

OF

CAPITAL

A

B

C

D EE F

Producers Equilibrium or the Least Cost Producers Equilibrium or the Least Cost Combination of FactorsCombination of Factors

A producer desires to minimise his cost of production for producing A producer desires to minimise his cost of production for producing

a given level ofa given level of output with the least cost combination of factors.output with the least cost combination of factors.

E

P

R

S

TIQ

IQ1

IQ2

LABOUR

CAPITAL

A

BO X

YHow producers ultimately arrives the point of equilibrium ?•The equilibrium is achieved at the point Where MRTS LK = PL/PK ie• The slope of isoquant =Slope of isocost•Or , MRTS LY = MPL = PX

MPK PY

Or, MPL = MPK PX PY

LABOUR

Expansion Path Expansion Path The Line joining the least cost combinations like a, b, c, d.The Line joining the least cost combinations like a, b, c, d. Expansion Path may be defined as the locus of efficient Expansion Path may be defined as the locus of efficient

combinations of the factors.combinations of the factors.

Expansion Path

y

o x

a

b

c

IC

IC1

IC2

LABOUR

CAPITAL

A

B

C

D E F

a) Increasing Returns to Scale:a) Increasing Returns to Scale:

Causes:Causes: Indivisibilities of Factors,Indivisibilities of Factors, High degree of specialization,High degree of specialization,

Labour

CAPITAL

b) Constant Returns to Scaleb) Constant Returns to Scale

Causes:Causes: Factors of production fully Factors of production fully

utilised.utilised. Technology remains Technology remains

unchangedunchanged

Labour

CAPITAL

c) Diminishing Returns to Scalec) Diminishing Returns to Scale

Causes:Causes: Managerial Diseconomies.Managerial Diseconomies. Scarce and Exhaustible Scarce and Exhaustible

resources.resources.

Labour

CAPITAL

Economies & Diseconomies of ScaleEconomies & Diseconomies of Scale

The Factors which cause the operations of The Factors which cause the operations of the Laws of Returns to Scale are grouped as the Laws of Returns to Scale are grouped as under;under;

Economies of Scale, relates to profit accruing Economies of Scale, relates to profit accruing to a business firm. Economies of scale are to a business firm. Economies of scale are classified as;classified as;

Internal economiesInternal economies External economies,External economies,

Internal EconomiesInternal Economies Economies in productionEconomies in production

• Technical advantages,Technical advantages,• Advantages of division of Labour and Advantages of division of Labour and

specializationspecialization Economies in MarketingEconomies in Marketing Managerial EconomiesManagerial Economies Economies in Transportation & storageEconomies in Transportation & storage

External Economies External Economies to large size firms arise to large size firms arise from the discounts available to it due to;from the discounts available to it due to; Large scale of purchase of raw material, Large scale of purchase of raw material, Finance at low rate of interest,Finance at low rate of interest, Low advertising cost,Low advertising cost, Low Transportation cost.Low Transportation cost.

DiseconomiesDiseconomies of scale are the losses of scale are the losses accruing to a business firm as a result of accruing to a business firm as a result of large scale production.large scale production.

Oligopoly MarketOligopoly Market

Price and Output Determination Under OligopolyPrice and Output Determination Under Oligopoly

Oligopoly is defined as the market structure in which Oligopoly is defined as the market structure in which there are a few sellers selling a homogeneous or there are a few sellers selling a homogeneous or differentiated products.differentiated products.

Selling homogeneous products – pure oligopoly. Selling homogeneous products – pure oligopoly. Example : industries producing bread, cement, steel, Example : industries producing bread, cement, steel, petrol, cooking gas, chemicals, aluminium and sugar. petrol, cooking gas, chemicals, aluminium and sugar.

Selling differentiated products – differentiated Selling differentiated products – differentiated oligopoly. Examples: Automobiles, TV sets, soft oligopoly. Examples: Automobiles, TV sets, soft drinks, computers, cigarettes etc. drinks, computers, cigarettes etc.

Features of OligopolyFeatures of Oligopoly

Small number of sellers : There is a small number of sellers Small number of sellers : There is a small number of sellers under oligopoly. Conceptually, however, the number of sellers is under oligopoly. Conceptually, however, the number of sellers is so small and the market share of each firm is so large that a so small and the market share of each firm is so large that a single firm can influence the market price and business strategy single firm can influence the market price and business strategy of the rival firmsof the rival firms

Interdependence of decision making : The competition between Interdependence of decision making : The competition between the firms takes the form of action, reaction, and counteraction the firms takes the form of action, reaction, and counteraction between them. Since the number of firms in the industry is between them. Since the number of firms in the industry is small, the business strategy of each firm in respect of pricing, small, the business strategy of each firm in respect of pricing, advertising, product modification is closely watched by the rival advertising, product modification is closely watched by the rival firms firms

Conti…Conti…

Barriers to entry arise due to such market Barriers to entry arise due to such market conditions as :conditions as :

Huge investment requiredHuge investment required Economies of scaleEconomies of scale Strong consumers loyaltyStrong consumers loyalty Existing firms can resort to the price Existing firms can resort to the price

cuttingcutting

Collusive Oligopoly: CartelsCollusive Oligopoly: Cartels

In order to avoid uncertainty arising out of interdependence and In order to avoid uncertainty arising out of interdependence and to avoid price wars and cut throat competition, firms working to avoid price wars and cut throat competition, firms working under oligopolistic conditions often enter into an agreement under oligopolistic conditions often enter into an agreement regarding a uniform price – output policy to be pursued by them. regarding a uniform price – output policy to be pursued by them. The agreement may be either formal or secret. when the firms The agreement may be either formal or secret. when the firms enter into such secret agreements, collusive oligopoly prevails.enter into such secret agreements, collusive oligopoly prevails.

Collusion is of two types:Collusion is of two types: a) Cartels.a) Cartels. b) Price Leadership. b) Price Leadership.

In a cartel type of collusive oligopoly, firms jointly fix a price and In a cartel type of collusive oligopoly, firms jointly fix a price and output policy through agreements.output policy through agreements.

Under Price Leadership one firm sets the price and others follow Under Price Leadership one firm sets the price and others follow it. The one which sets the price is a price leader and the one it. The one which sets the price is a price leader and the one who follow him are his followers.who follow him are his followers.

Price and output determination under cartel: - Joint profit Price and output determination under cartel: - Joint profit maximizationmaximization

Price and Output Determination Under Low-Cost Price Price and Output Determination Under Low-Cost Price Leadership.Leadership.

Price Leadership By The Dominant FirmPrice Leadership By The Dominant Firm

The Kinked Demand Curve Theory of OligopolyThe Kinked Demand Curve Theory of Oligopoly

The Kinked Demand Curve Hypothesis was put forward by Paul The Kinked Demand Curve Hypothesis was put forward by Paul M. Sweezy & by Hall & Hitch.M. Sweezy & by Hall & Hitch.