Production Production Is an organized activities of converting

inputs into output or creation of value and utility

Factors of production – Rewards Land - rent Labor - wages Capital - interest Organization - profit

Production function

Production function –The functional relationship between

physical inputs and physical output

Production FunctionWith One Variable Input

Total Product

Marginal Product

Average Product

Production orOutput Elasticity

TP = Q = f(L)

MPL =TP L

APL =TP L

EL =MPL

APL

Production FunctionWith One Variable Input

L Q MPL APL EL

0 0 - - -1 3 3 3 12 8 5 4 1.253 12 4 4 14 14 2 3.5 0.575 14 0 2.8 06 12 -2 2 -1

Total, Marginal, and Average Product of Labor, and Output Elasticity

Production FunctionWith One Variable Input

Production FunctionWith One Variable Input

Production function 1. Production function for a firm is Q = 100L – 0.02L2. If

10 units of labor are used, What is the maximum average productivity of labor?

2. If the average product of labor (APL) is 30L – L2, What is the maximum possible total product (TPL) ?

3. The Production function of a manufacturing unit, using only labor (L) as inputs in the production process, is estimated to be Q = 100 L2 – L3. What is the number of labor input at which the firm can maximize average productivity ? and What is the maximum average

productivity at that input level?

Optimal Use of theVariable Input

Marginal RevenueProduct of Labor

MRPL = (MPL)(MR)

Marginal ResourceCost of Labor

MRCL =TC L

Optimal Use of Labor MRPL = MRCL

Optimal Use of theVariable Input

L MPL MR = P MRPL MRCL

2.50 4 $10 $40 $203.00 3 10 30 203.50 2 10 20 204.00 1 10 10 204.50 0 10 0 20

Use of Labor is Optimal When L = 3.50

Optimal Use of theVariable Input

Production With TwoVariable Inputs

Isoquants show combinations of two inputs that can produce the same level of output.

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.

Production With TwoVariable Inputs

Isoquants

Production With TwoVariable Inputs

Economic Region of Production

Production With TwoVariable Inputs

Marginal Rate of Technical Substitution

MRTS = -K/L = MPL/MPK

Production With TwoVariable Inputs

MRTS = -(-2.5/1) = 2.5

Production With TwoVariable Inputs

Perfect Substitutes Perfect Complements

Optimal Combination of Inputs

Isocost lines represent all combinations of two inputs that a firm can purchase with the same total cost.

C wL rK

C wK L

r r

C Total Cost

( )w WageRateof Labor L

( )r Cost of Capital K

Optimal Combination of InputsIsocost Lines

AB C = $100, w = r = $10

A’B’ C = $140, w = r = $10

A’’B’’ C = $80, w = r = $10

AB* C = $100, w = $5, r = $10

Optimal Combination of Inputs

MRTS = w/r

Production function

1. Production function of a firm is Q = 4L2 + 6K2 – 2LKBudget constraint of the firm is Rs.720. The market going wage rate w =

Rs.10 and cost of capital r = Rs.10a.The optimum input quantities of Labour and Capital and the output at

that input  quantitiesb.The optimum output if both the wage rate and cost of capital increase to

Rs. 15.2.Suppose the price of labour is Rs.10 and the price of capital is Rs.2.5 Use this information to determine the isocost equations corresponding to

a total cost of Rs.200 and Rs.500 Plot these two iso-cost lines on a graph If the price of labour falls from Rs.10 per unit to Rs. 8 per unit,

determine the new Rs.500 iso-cost line and plot it on the same diagram used in part (b)

Optimal Combination of Inputs

Effect of a Change in Input Prices

Returns to Scale

Production Function Q = f(L, K)

Q = f(hL, hK)

If = h, then f has constant returns to scale.

If > h, then f has increasing returns to scale.

If < h, the f has decreasing returns to scale.

Returns to Scale

Constant Returns to

Scale

Increasing Returns to

Scale

Decreasing Returns to

Scale

Returns to ScaleReturns to Scale

Constant Returns to

Scale

Increasing Returns to

Scale

Decreasing Returns to

Scale

Innovations and Global Competitiveness

Product Innovation Process Innovation Product Cycle Model Just-In-Time Production System Competitive Benchmarking Computer-Aided Design (CAD) Computer-Aided Manufacturing

(CAM)

Economies of scale and scope

Internal economies External economies

Internal economies

Labor economies Managerial economies Financial economies Marketing economies Technical economies

External economies

Economies of localization Economies of marketing intelligence

and information Economies of vertical disintegration Economies of byproducts

Basic cost concepts Explicit cost and Implicit cost Opportunity cost Marginal cost and incremental cost Real cost Controllable cost Traceable cost and common costs Fixed cost and variable cost

Short-Run Cost Functions

Total Cost = TC = f(Q) Total Fixed Cost = TFC Total Variable Cost = TVC TC = TFC + TVC

Short-Run Cost Functions

Average Total Cost = ATC = TC/Q Average Fixed Cost = AFC = TFC/Q Average Variable Cost = AVC = TVC/Q ATC = AFC + AVC Marginal Cost = TC/Q = TVC/Q

Short-Run Cost Functions

Q TFC TVC TC AFC AVC ATC MC0 $60 $0 $60 - - - -1 60 20 80 $60 $20 $80 $202 60 30 90 30 15 45 103 60 45 105 20 15 35 154 60 80 140 15 20 35 355 60 135 195 12 27 39 55

Long-Run Cost Curves

Long-Run Total Cost = LTC = f(Q) Long-Run Average Cost = LAC =

LTC/Q Long-Run Marginal Cost = LMC =

LTC/Q

Long-run average cost curve

Learning and costs Job familiarization and less time to instruct

workers More skillful movements of workers Better operation sequences, machine-feeds

and speeds Less rejection and rework Manufacturing lots are larger, cutting down the

set-up time proportion Improved coordination and management

controls

Learning Curves

Minimizing Costs Internationally

Foreign Sourcing of Inputs New International Economies of Scale Immigration of Skilled Labor

Logistics or Supply Chain Management

Merges and integrates functions Purchasing Transportation Warehousing Distribution Customer Services

Source of competitive advantage

Logistics or Supply Chain Management

Reasons for the growth of logistics Advances in computer technology

Decreased cost of logistical problem solving Growth of just-in-time inventory management

Increased need to monitor and manage input and output flows

Globalization of production and distribution Increased complexity of input and output flows

Tools of cost control

Budgetary control Standard Costing Ratio analysis Value analysis

Areas of cost control

Material cost Labour cost Overhead cost Selling cost

Approaches to cost reduction

Budgetary Input reduction Input cost Input substitution “Not made here” Suggestions box

George Stigler’s Survivorship Technique

Classify various firms in an industry under study by size groups or classes

Determine which size groups or classes are increasing or decreasing their share of the total output

If the share of a given size-class falls, that size class is relatively inefficient and in general, more inefficient the size group, more rapidly the share falls. Likewise, the size-class whose share in industry grows the most, is regarded as most efficient size- class or group

The technique gives the optimum size of a firm only and that too in terms of output range or the size group. Butit does not yield the cost function

Cost-Volume-Profit Analysis

Total Cost-Volume-Profit Analysis Revenue = TR = (P)(Q)

Breakeven Volume TR = TC

(P)(Q) = TFC + (AVC)(Q)

QBE = TFC/(P - AVC)

Cost-Volume-Profit Analysis

Operating Leverage

Break Even Analysis

TR = TC In units - BEP = TFC/CM In value - BEP = TFC/ P.V.Ratio

Managerial Applications of BEP

Price and Cost decision Target Profit Margin of safety Product mix decision Selection of technology Decision on promotional expenditure Make or buy decisions