MODULE 3

PRODUCTION ANALYSIS

PART A - EACH QUESTION CARRIES 2 MARKS

1. Define production?
According to J.R. Hicks "production is any activity whether physical or mental, which is
directed to the satisfaction of other people's wans through exchange".

2. What is production theory?

Production theory studies the relationship between various possible combinations of input
and output. In at words, production theory tells how factors of production are combined to
produce the outputs.

3. What is Cobb - Douglas Production Function?

A famous empirical production function was formulated by C.W. Cobb and Paul. H. Douglas
of USA on the basis of their study about production function of American manufacturing
industries. Cobb - Douglas production function is stated as
Q= KLaC(1-a)
Where Q = Output
K = constant which represents the state of technology
L = Labor input
'a' = positive fraction which indicates the proportion between inputs
C = Capital input .
According to Cobb - Douglas production function 75 % of the increase in output in the
manufacturing industries of USA is due to labour input and the remaining 25 % is due to capital
input. In other words, Cobb - Douglas finds that a one percent increase in labour will increase
output three times as much as would a one percent increase in capital.

4. What is total product?

Total product of a particular quantity of input is the amount of total output produced by a
given amount of input, keeping the level of all other inputs unchanged. If 5 workers can
produce 15 tables a day, the total product of labor input (5 workers) is 15 tables .

5. What is average product?

Average product Average product of a particular input is the amount of output produced by
that input divided by the quantity of that input used. Thus the average product of labour input
is
APL = Q/L
Where APL= Average product of labour
 Q = Total product produced by labour input
L = Quantity of labour input
For example, in a bakery if 20 workers can make 200 cakes per day , the average product of 20
workers is 10 cakes per day .

6. What is marginal product?

Marginal product of any factor of production is the addition to total product as a result of
employment of an extra unit of a factor. It can be defined as the addition made to the total
output by the application of one more unit of variable input.

7. What are the types of production function?

There are two types of production function.
a) Production function in the short – run
In the short run inputs like land, machinery, equipments, etc , arc fixed at certain quantities cannot
be varied within a short span of time . However inputs like labour, rawmaterials etc. can be varied.
Increases in output in the short run is possible only by adding more variable inputs.
b) production function in the long run.
In the long run all inputs are variable inputs and output can be increased by increasing both fixed
as well as variable inputs.
PART B - EACH QUESTION CARRIES 5 MARKS

8. What is production function and what are the assumptions of production function?
Production function is defined as the functional relationship between physical inputs and
physical outputs. Production function can be expressed algebraically as
Q = f (a, b , c , ..... )
Where Q = The output of a commodity per unit time
f = function of or depends on
a,b , c , ... are the quantities of various inputs like land , labour , capital etc.
It is clear from the above equation that the quantity of output of a commodity depends upon the
quantities of inputs used. “A production function summarizes the relationship between labour,
capital and land inputs and the maximum output these inputs can produce. It tells how much output
can be produced from a given combination of inputs and tells by how much output will increase if
one (or all ) input ( s ) increase." A firm has two types of production function. Short run
production function and long run production function. depending up on the time required to
change input levels Economists distinguish between short run and long run." The short run is a
period of time so short that the existing plant and equipment cannot be varied; such inputs are fixed
in supply Additional outputs can be produced only by expanding the variable inputs of labour and
raw materials. The long run is a period long enough to vary all inputs".
Assumptions of Production Function
Production function is based on the following assumptions.
1. It has reference to a particular time period: Production function the relation between inputs and
outputs over a period of time .As the time period changes production function also changes . The
same inputs can produce different outputs both in the short run and long run. In the long run a
producer has more choices than in the short run because all the inputs can be varied in the long
run.
2. State of technology does not change: The state of technical knowledge is assumed to be constant
for specifying a production function. If the technology advances production Function also changes
because now it is possible to produce more output from a given set of inputs with the advanced
technology or lesser quantities of inputs can be used for producing a given quantity of output.

9. What are the managerial uses of production function?

The following are the managerial uses of production function.
1. To calculate the least cost input combination: It helps managers to find out the least cost input
combination to produce certain quantity of output. It is a useful tool which helps to substitute
costly inputs with the less costly inputs.
2. To calculate the maximum input out combination: It can be used to calculate the maximum input
output combination for a given cost.
3. To decide on the value of employing a variable input factor: It is profitable to increase the use
of a variable input as long as the marginal revenue of a variable input exceeds it price . The
additional use of a variable input must be stopped when the marginal revenue is just equals its
price.
4. To help in long run decision making: Law of returns to scale helps long run decision making.
If the returns to scale are increasing, it is worthwhile to increase production by proportionately
increasing all the inputs. The opposite will be true if there is diminishing return to scale. The
producer will be indifferent about increasing or decreasing production in case of constant returns
to scale.

10. What is isoquant and what are the properties of isoquants?

Isoquant represents various combinations of two inputs that can produce the same output.
The two inputs are capital and labour. ' Iso ' means same and ' quant ' means quantity. So Isoquant
means same quantity. Isoquant curve is a curve which shows all possible combinations of capital
and labor inputs that can produce the same quantity of output. It is also known as Isoproduct curve
or equal product curve or product - indifference curve. An Isoquant map with a set of four
Isoquants for the production of 50 units, 100 units, 150 units and 200 units diagrammatically
shown below
Properties of isoquants
Isoquants The following are the three main characteristics of Isoquant.
1. Isoquants slope downward from left to right - Isoquant curves slope downward from left to right
(negative slope) It means that if the quantity of one input is decreased , the quantity of another
input must be increased so as to maintain the same quantity of output
2. Isoquants are convex to the origin - Isoquants are convex to the origin because of the diminishing
marginal of technical substitution.
3. Two Isoquants never intersect - Two Isoquants cannot cut each other. It means that an input
combination that can produce a particular quantity of output cannot produce another quantity of
output in a given state of technology.

11. What is Iso cost curve?

Iso cost line shows all the combinations of labor and capital that a firm can buy with a given
amount of money. Iso cost curve diagrammatically shown below
The above Iso cost line shows all the combinations of labour and capital that a firm can buy with
Rs. 600 and Rs. 700.

12. What do you mean by optimum combination of input?

Optimum combination of inputs or least cost inputs combination is that combination of
inputs which produce the product at the minimum cost.
Optimum combination of inputs is found out with the help of isoquant
and iso cost curves as shown below. Assume that a producer decides to produce 50 units of output
by spending 600. It can be produced by any of the combinations of inputs A, B, C which lie on the
Isoquant curve Iq. Among these combinations he has to choose the one which gives him lowest
cost of production. Iso cost curve MR shows the different among these combinations of inputs
which can be purchased for 600. The optimum combination lies at combination B where Iso cost
line MR is tangent to the lsoquant curve Iq. The producer can produce 50 units of output for Rs.
600 by using B combination of labor and capital. He would not like to choose combination A or
C because all these lie on the higher Iso cost curve. It means that de producer has to spend 700 for
producing 50 units. Thus it can be concluded that the optimum combination of inputs lie at the
point of tangency between Isoquant curve and Iso cost curve.
 PART C - EACH QUESTION CARRIES 15 MARKS

13. Explain law of diminishing returns.

The law that deals with production function in the short – run is called Law of diminishing
returns or Law of variable proportions. Law of Diminishing Returns or Law of Variable
Proportions Law of diminishing returns examines the input output relation when the output
is increased by varying one variable input. As per the law of diminishing returns if the quantity
of a variable input is increased continuously, keeping the quantity of other inputs constant, the
output will first increase but after a stage the output will decline.
There are 3 stages of the law of diminishing returns.
1. Increasing returns.
At this stage total product increases at an increasing rate . The marginal product of workers
(contribution from each additional worker) also increases at this stage. As the total product
increases the average product also increases.
2. Diminishing returns
The total product continues to increase but at a diminishing rate. This stage ends until the total
product reaches its maximum. At this stage both average product and marginal product of
variable input diminishes but marginal product remains positive with zero marginal product at
the end of this stage.
3. Negative returns.
Both the total product and average product declines and the marginal product turns negative.
Nobody would like to operate in the third stage. The law of diminishing returns and its 3 stages
are diagrammatically shown below
 The law of diminishing returns operates on the following assumptions
1. Production technology does not change: the law of diminishing returns operates only under a
given state of technology. If there is an advancement in production technology the marginal and
average products may increase instead of diminishing
2. The variable input is identical : The law assumes that all the units of the variable input are
identical in size or productivity . For e.g. If one worker is more efficient than the other the output
may increase instead of falling.
3. Only one input is varied : The law assumes that only one input is varied while others are kept
constant. This is done in order to find out the effect of a particular variable mput on the output. If
more than one input is varied simultaneously, it is difficult to know due to which input the output
has increased.
4. Fixed input is indivisible : There are certain fixed inputs which cannot be obtained in the size
and quantity that suits to the requirements of variable inputs , eg: machines . The law assumes that
the capacity of fixed input cannot be divided and used for some other production .
Reasons for the Operation of the Law
The law of diminishing retums occurs due to the following reasons.
1 Indivisibility of fixed inputs : As the fixed inputs are indivisible the quantity of fixed input is
relatively more than the quantity of variable inputs at the initial stage. As more and more units of
variable input are added, the fixed input is fully and efficiently used and therefore the output
increases rapidly in the first stage. Then a stage will come when the fixed indivisible input is used
in optimum proportion with variable factor . As variable inputs are further increased to utilization
of fixed input becomes non-optimal with variable factor and ta causes the output to decline.
2. Scarcity of fixed inputs : In the short run it is not possible to increase the fixed inputs. Therefore
fixed inputs are not increased in proportion with the increase in variable inputs. This causes the
output to diminish as more and more additional units of the variable input are used.
3. Imperfect substitutes : Mrs. Joan Robinson says "what the law of diminishing returns really
states is that there is a limit to the extent to which one factor of production can be substituted for
another " . When more and more variable inputs are substituted for fixed inputs , the productivity
falls and the the law of diminishing returns occurs.
Role of Law of Diminishing Returns in Decision Making
The law of diminishing returns has a great role to play in the decision making process of business
firms.
1. It helps a businessman to know how many units of a variable input should be used with the fixed
input to get the maximum output.
2. It also helps to know the quantity of output that can be produced with different combinations
of fixed and variable inputs.
3. The principle of marginality as used in the law of diminishing returns focus on the need for
comparing cost and benefit before taking business decisions. Marginal revenue is the benefit
obtained from employing an additional input and marginal cost is the cost of acquiring an
additional input. It is profitable to employ more inputs as long as the marginal revenue is more
than marginal cost.

14. Explain law of returns to scale.

The law that deals with production function in the long run is called law of returns to scale.
Law of returns to scale examines the input output relation when all the inputs are changed
simultaneously in the same ratio. Law of returns to scale has 3 phases depending upon the
magnitude of effect on output due to simultaneous change in all the inputs .
1. Increasing returns to scale
Increasing Returns to Scale Increasing returns to scale occurs when the increase in output is more
than proportionate to increase in input. Increasing returns to scale leads to increase in marginal
product. The following are the reasons for increasing returns to scale
( a ) Indivisibility of fixed inputs : As fixed inputs indivisible there is greater scope for full and
efficient use of fixed inputs at the initial stages . This leads to increase in output
( b ) Increased division of labour : As the input combinations are increased , there is more scope
for division of labour and specialization.
2. Constant returns to scale
Constant Returns to Scale Constant returns to scale occur when the increase in output is
proportionate to increase in input. At this stage there is no change in the marginal product.
Constant returns to scale appears when the input combination reaches a certain point where there
is no further scope for division of labour.
3.Diminishing returns to scale
Diminishing Returns to Scale Diminishing returns to scale occurs if the increase in output is less
than proportionate to increase in inputs. At this stage the marginal product diminishes.

15. Explain the economies and diseconomies of large scale production.

Econmies of scale
When a business firm grows in size or increase the scale of operations it can derive production
advantages from market and firm size in terms of low average cost of production. Such production
advantages due to large scale operations are known as economies of scale. "Economies of scale
are present when an increase in output causes long run average cost to fall.” The fall in
average cost of production is because of increased productivity resulting from specialization in
areas like production , marketing , research and development , management etc. The division of
labour can become much more specialized in large firms as compared to small firms .
The economics of large scale operations may be classified into internal economies and external
economies
A) Internal economies
Internal economies are those economies which accrue to a single firm due to its increase in scale
of operations. The source of internal economies to a large firm is from the use of more efficient
production methods and efficient management of resources. According to Alfred Marshall "the
chief advantage of production on a large scale are economy of skill , economy of machinery and
economy of materials " . Internal economies may be of the following kinds;
1. Technical economies : arise out of the use of most modern production technology which can
reduce the cost of production per unit. A large firm, as it increases production can make use of
the optimum utilization of plant and machinery . A large firm can afford to make use of the most
modern technologies while a small firm must satisfy with the primitive technologies.
2. Economy of labour : In a large firm division of labor is much more specialized than small firms.
Division of labor and specialization increases efficiency of a firm. Since the output of a large firm
is higher it can employ large number of employees with specialized skills so that they can
concentrate on specified tasks. As the number of employees are less in a small firm, an employee
has lo perform many tasks and it makes him jack of all trades but master of none. Moreover he
losses much of his time in moving from one task to another.
3. Managerial economies : When production is carried on a large scale it is profitable to group the
activities of a business enterprise into production , marketing , finance , human resources etc. Each
group is headed by well qualified and experienced professionals who can direct their subordinates
to perform their tasks in the most efficient way.
4. Commercial economies : A large firm can have economy in buying and selling of goods. The
economies occurring from buying and selling is called commercial economies. It is also called
economy in transport and storage . Economy in buying arises from bulk buying , bargaining
advantages , better credit terms from suppliers , prompt delivery of raw materials etc. Bulk buying
enables a firm to reduce ordering cost and transportation cost. Economy in buying helps a firm to
sell its products at a reduced rate. A large firm can afford to have a wide network of retail outlets
in important areas where sales potential is more. It can also satisfy its customers by providing
after - sale services and establishing customer care centers depending upon the nature of the
product.
5. Economy of capital : A large firm can satisfy its fixed capital and working capital requirements
without much difficulty. It can borrow money from banks and financial institutions on more
favorable terms. It can accept deposits from the public and issue shares and debentures for raising
capital. Therefore the cost of capital of a large firm will be lower than that of a small firm.
6. Risk bearing economies : A large firm is healthier enough to bear the risks associated with
business . Through diversification of business activities a firm can compensate the risk from one
product with the profit from another product. A large firm can withstand in the market even while
there is a temporary fall in the market demand in times of economic depression.
B) External Economies:
External economies are those economies that accrue to the whole of an industry arising from the
localisation of industry. When most of the firms in an industry set up their factories in one
particular area it is called localization of industry. External economies may be grouped under the
following two leads.
1. Economies of concentration : These are the benefits derived by all the firms in an industry
because of the localisation of industry. They are;
 Development of transport and communication facilities
 Availability of credit facilities due to development of banking system in the area
 Establishment of raw - material suppliers, marketing and advertising agencies , waste
treatment plants etc in the immediate vicinity of the industry .
 Support from government and governmental agencies in the form of infrastructure
development, power generation etc.
2. Economies of information:
Economies of information can be derived by all the firms in an industry through the publication of
trade and technical journals. Research and development requires huge investments and therefore
through a central research agency all the firms in an industry can get the benefit of research and
development. Thus firms in a localized industry enjoy the benefit of research and development at
a relatively small amount of expenditure than the firms in a scattered industry.
Diseconomies of scale
Diseconomies of scale are present when an increase in output causes long run average costs
to increase. Therefore it is profitable for a firm to maintain an optimum size. An optimum firm
is a firm whose scale of operations are expanded to such a level the cost of production is at the
minimum. There would be no motive for further expansion once a firm reaches its optimum size.
If a firm expands beyond the optimum size the long run average cost begins to increase.
Diseconomies of scale may be internal or external.
 a) Internal diseconomies
Occur due to the complexity of organization. As a firm expands beyond an optimum size the
organization becomes so complex that the management may find it very difficult to manage the
affairs of a firm in spite of delegation of powers to middle level and junior level management
b) External diseconomies
When an industry in a localised area is expanded beyond an optimum size external diseconomy
creeps in . It may be in the form of increase in factor prices . Because of competition among firms
prices of rawmaterials may go up, higher wages have to be paid for labour, higher rents for the
buildings, higher rate of interest for capital . All these eventually lead to increase in cost of
production.