Scribd
Upload
4 views

Supply Chain

Basics of scm

Uploaded by

Aresh Bhatnagar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF or read online on Scribd
4 views

Supply Chain

Basics of scm

Uploaded by

Aresh Bhatnagar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF or read online on Scribd
You are on page 1/ 29
organisation fOr comic theory of social wer “In its broad. cial element of the economic SO soyernmental control. cee) oe yadest formulation eee) ace ion and the role (and locus GEORGE J. ST! underlies every question of market organisation @ ecanomic life.” 10 Supply And Production Decisions Learning Objectives : After going through this chapter, the reader shoul © understand the law of supply identify the determinants of supply and production © analyse the various laws of returns © comprehend the isocost-isoquant analysis © appreciate the various aspects of empirical production function. \d be able to: 10.1. THE LAW OF SUPPLY i ‘Supply ofa commodity refers to the various quantities ofthecommodity which a seller is willing and able to sell at different prices in a given market, at a point of time, other things remaining the same. An aspect of supply which needs attention is that supply is related to scarcity. It is only the scarce goods which have a supply prict; the goods which are freely available have no supply price. 10.1.1. The Determinants of Supply 84 So 1 z | 274 { E64 | 85] i S44 i ead | $4 i “000 units) 81 Quantity of Tyres ( 34] = 5 15 3 Fig. 10.1. The Supply Curve “ol Big ut : COL “Sty UE UMOYS pue 7-61 aIqRL UI UDAIR axe somronse[a Ajddns Jo spury UHEY!p EL Ayonsepa Ajddns Jo spun “T'7O1 st Ayddns oyeuro} a1 ‘onsejouy 24 08 pres sds cra pre nn sw ues wes ope sea 30 9 a8uey 1 Jo oolld op mt oftreyo yao aT St ae Jo Ayddns ayy ‘pariddns unowe syt ut aueyo yua0 49d ¢ 0 spea| sedNs ayeuonsodaid ue sso] 01 va a jurexa 404 “onsejaut oq 01 spuay Aqddns aup ‘payddns Awuenb ur aduey> uy aBueyp ouy 04 Ajareu oak pum ur aueyo oup 1 puey 1oyro oy) UE “oHse|2 9q 0} spuar Ajddns ayp “sou pamnaeiert ‘uey} asow safueys poyddns Anuenb ayp usym “Arypowuos roys fo aotad ur 1 parddns Asnupnb fo ssauaaisuodsas ay sv pourfap 8} kiypoumos v fo &yddns fo Musryy X1ddM$ dO ALIOLLSV 19 “o C0 TOL Bt ee e aaino Ajddns ay) Zuoye smoue Jo djay ayy ym uMOYs aue asoyy, ‘AIddns us UoHORAUOD SMOYS 2AIN'D dns # uo spreaumop woutonou v pue Ans wr uorsuoxo sre sna éyddns © wo spaemdn quowlenous b ‘spsom satno uy Ajddns fo uonapauos payjvo si 11 (221d ®y 19 GO) aotad samo] v 1 payjddns 210 Pood ay fo siun ssay uayss pun ‘yddns fo worsuarxa ays payyno st 31 ‘(29tad | 10 'GO) artad s9yB1y 10 payddns auv poos ay fo sun aiou wayyy ‘Ayddns fo uona4su09 puo worsuasxa ays ‘sanf ur ‘st &jddns uj a8u0y4.) Aiddng wi aBuey5 pue ytus 701 Ba 37posp ge Aan 6° _.6 i XX poy Jo 204d, bo pue GO anyer 5% “Aypansadsou Zség aijddns ase sannuenb “30 Pur ,"GO aque “sg st onan Atddns ways pur isis aye sonano ea 1s pe aod C55 01 ES wD YL AYE BAIR Ayes 24 =: pans st Aten °BO 29 ogg wo) ya ayp 03 ano Aqddns oyp UL yIYS ® Aq uasoys st Ayddns ut {hq Addins us aseas0aP © OLN TT ype poriddns “Gnuenb ut asvaioop 40 osvasout seat Ayddns wi yiys asvasout ayy 7°01 “Std UI? Aqddng ut aBueyy pur Aiddng wy yryg “¢-1-01 “soseasout os aap jo aoud ayn se21 “ado annsod w sey 24an9 6iddns yey 210N 7 oa oy pouedan! 0 PINON Watson Yow 2d uM ay SHxOyS ory ids Jo suonspu09 uonia 29pun Pood ot Jo 2oud ayqissod yes fo runowe wnuIKeU a SMOYS BAND Ajddns ou wauy/ dap aauno Kddns a4) Uo juI0d y90g “oaano Ayddns § way {vont Amnuenb pue aotud Jo suoMeUIquiod xIs oy 10}d, sje pauiddns Anuenb su! S9S822 Pr 1p ou ood ayy jo swunowe 1u>/eHy pam se eeino gyddns suaty 243721 £05 O° oof aut ge ppes 09 BUTT 24 PINOT eg pyonb- 221d ‘ayy S191 1D pandas “ne ey Ul ayy fo suonmurque: fot pue 01 A1%eL oe oan 8 0 au ® A ns yn 0 HHO SE "yvomonun Seip ponuasaudad wo4n 2ympayox éyddns ayy “Bal am (1-01 081 comuouory (14250UIN O.dv | d/av (ov) 4 Ov IOV Aupouuos ay) jo aoud ayy us afuryo annie} _ eg, Aypouruos aq) jo payddnw Aynuenb wt ouey> aAHe1°RL Ajdds 30 Ay 11m pounstoU 09 WED nynuusoy Burmojjoy ay) Jo djoy aa one Supsnse2q Jo spose “7-779 Auddns ayy ‘sive ewozuoy ayy sino yuofluey asaya ‘9 juIod We 7 1 so fds 0 son 2 a8 a ees sossnd juabumy out ‘onan Ajddns oy) jod yoy) aw aang Ajddns oyy 0} UoBUE, Fur [paunseaw! 2q we9 wuiod Aue ye Aarons si ‘OU pons: A Auonse(g Aiddng fuunseay, p91 By anim Ayddng jo X poop jo sun A poog jo sup) By ut S689) anana Ayddni 19 Ayaan oja 8 Saye (EOL By wis "ya 4H 's4§) wrBu0 ayn yBinosyy Bur 1 PIES 81 poo aq “2oud wi aBuryD ayy se uoriodo A ay) Hino BAano Aiddns oy) UoH94 nano Addn onwoj9 Kaeyun ype Sue 941 UI KoBuRYD poriddns dan kant 2410 ited ' ons idm ayy kq unos way pe ve afury> 10u sa0p payiddns rnb oun Adds opsojauy yzafuad 40 Anousoya o “Auuyyut 9q 04 pres 97 Os) amwO4DUI O} Ajddns 494)10 Uf ‘9]B8 404 pasayo s1 2 Gans 89 Arsafiad 40 ayy Managerial Economics 182 clasticity of supply of the commodity: original quantity supplied of the commodity: AQ = change in the quantity supplied; P= original price of the commodity: change in the price. ¢ increases to Rs. 10 per Wstration 1 supplied 2,000 pens at price of Rs. 8 per pen. era bs Pen. the supply of XYZ increa Find the elasticity of supply es to 3,000 p Solution: The initial price (P) =Rs.8 Change in price (AP) =Rs. 10—Rs. 8= Rs. 2 ‘The initial quantity supplied (Q) = 2,000 pens Change in ae - (AQ) = 3,000 ~ 2000 = 1000 pens ag P ee +. Elasticity of supply -73?P'O 2 10.2.3. Determinants of Elasticity of Supply. Elasticity of supply is determined by the following factors oe (®) Time. Time period can broadly be classified into three categories : (a) Market period is the one where supply is fixed as no factor of production can be varied; (b) Short period is defined as the time period where itis possible to adjust supply only by altering the variable factors, like raw material, labour, etc.; and (c) Long eriod is the one where supply can be altered at will because all the factors can be changed. Obviously, in the market period where the supply is fixed the elasticity of supply of the commodity will be zero. Whereas the clasticity will be higher in the long run than the short run because the possibility of altering output is limited in the short run but not in the long run. (ti) The relationship between minimum supply prices of diferent firms. fall the firms selling a particular commodity offer their supply to the market at more or less the same minimum price, supply of each of these will fend to be elastic at that price. Ina similar manner, when minimum price of the commodity rises, a greater number of firms come in, so greater will be the elasticity of supy ply. id) The cost of attracting factors of production. Additional amounts of factors are needed to expand outhut In ease output of an industry rises this means that higher factor prices will have to be paid. The relevant question in this context is: how much the mover Higher the proportion particular construction rice of the houses will + will therefore move to the left. 4 ment of thes activity, say houses, has elastic demand, the small risen sha cs eee Surve Now, ifa Cause a considerable contraction of the demand for houses pie oo therefore, the pi wp and Production Decisions 3.THE THEORY OF PRODUCTION - supply ofa product refers to its quant : : ty which the selleri sheproduct is known, its quanta e seller isready to off eee eames oe wy rupli rests on factors like paiaaereenen as eneen ireromic activity. al efficiency, et In production analysis we study these or 103.1. Meaning of Production Production is an activity that tra S an insforms inputs i t door raw material like sugarcane, nputs into output. For example, a sugar mill uses such inputs as process of transformation can be : iachinery, factory building to prod ae i ing to produce sugar. This ates ige in form (e.g. wood into furniture), a change in space (e.g, rail usability of goods and materials. AS st cold storage). These three kinds of transformations. help in enhancing cervices—both tangible like steel ete) and i ‘hus, volves producing, toring and dsbuting gods and s .) and ina i Sin bier cease useality Sie banking, insurance etc.). Production is, thus, an. 10.3.2. Factors Affecting Production and capital invested in i Technology. A firm’s production behaviour is fundamentally determined by the state of technology. Existing technology sets upper limit for the production of the firm, irrespective of the nature of output, size of the firm or the kind of management. Inputs. There are wide variety of inputs used by the firms, like various raw materials, labour services of different kinds, machine tools, buildings, etc. All inputs used in production are broadly classified into four categories: land, labour, capital and entrepreneurship. Land is all that is gifted by nature, while the physical and mental human effort spent in producing goods and services is labour. Capital is the man-made means of production like machinery, factory building, etc., and thé entrepreneur coordinates the inputs and takes risk of business. Each of these categories can be further subdivided. For example, we have skilled, unskilled and semi-skilled labour. Broadly, the inputs are divided into two main groups—fixed and variable inputs. A fixed input is the one whose quantity cannot be varied during the period under consideration. Plant and equipment are examples of fixed inputs.! An input whose quantity can be changed during the period under consideration is known as a variable input. Raw materials, labour, power, transportation, etc., whose quantity can often be increased or decreased on short notice are examples of variable inputs. “Time Period of Production. The fixity or variability of an input depends on the length of time period under consideration, Shorter the time period, more difficult itbecomes to vary the inputs. Economists classify time period into two categories: the short-run and the long-run, The short-run is that period of time in which some of the firm’s inputs are fixed—these fixed inputs act as limiting factor on change in output In practice, the short-term is generally understood to mean the length of time during which firm's plant and equipment are fixed. On the other hand, the Zong-term is that period of time in which there are no limiting factors on output change. In other words, in the long run all inputs can be changed. __10,3.3. The Production Function © The production function is purely a technological relationship which expresses the relation between output ofa good and the different combinations of inputs used in its production. It indicates the ‘maximum amount of output that can be produced with the help of each possible combination of inputs. Production function can take many forms, one of them might be Q = K? + K? + 2KL?, where Q, K, afd L are the output, capital and labour respectively. Another form of production function may be 0 = K2L", And, so on. ‘The production function is written mathematically as O=F (LN Ku) (10.3) | Plant and equipment ar taken ds fixed inputs because the cost of quick variation in them is often so large that such achanee becomes imprudent. Managerial Economics 184 e i jount of output. The Where L, K, and N are amounts of land, capital and labour respectively and Q is the am Production function rests on two main assumptions: ion of the input-output (® Technology is invariant. If technology changes it would result in alteration o} 1 relationship, resulting in a production function, ; eee oe (ii) It is assumed that firms utilise their inputs at maximum levels ocetieeee boteies ited Production function includes all the technically efficient methods of pro‘ vativotion ftom: if it includes includes only a single technical efficient method, we call it a Ce ee eer ‘So efficient processes it is a two-process production function, and so on. The the infinite process function. i to a two-input Although a firm often uses several inputs, for simplicity we may restrict our see diet fa ‘case (whose result can be generalised to the situation of more than two inputs). function of the form: Q=f(L. kK). where L and K are labour and capital respectively and Q is quantity of output. A hypothetical production function is displayed in Table 10.3, where different amounts of output (Q) resulting from various combi ven. For example, the use of 4 units of Land 2 units of K yields GO units of output Te ase ee a be used © highlight the difference between Table 10.3. A Hypothetical Production Function Units of Labour (L) Output Quantity (Q) 6 6 80 88 95, 5 i) 65 85 95 90 : @ 8s a @®) 15 2 @) ' ® : 2 3 4 3 6 units of capital (x) 2. Note that a technically, ‘cent method isnot necesarly economically efficient, For example, feo lity Xcan be by two methods, 4 and B: yy or example, ifeommodity X can be produced a8 Labour 29 Capital a3) eee a ty Sects ection, cormpared ts rosin, efficient methods, as inefficient methods will . thod “4. The basi not be used| © theory of production concentrates only on roduction functor Now take another example. Ifprocess 4 uses lens of, : mn will include only process 4. eames be Grey compurson he asi oft eh cen Reece ete Ar compared proces ten fd bea > For example, let the activities 4 and B ee ms fae by rational entrepreneurs. Sop some f Supply and Production Decisions 185 short-run and long-run changes in production function. In the short-run at least one of the inputs remains constant, while the other inputs vary. Each of the rows refers to output levels when capital varies (with labour constant), while each column represents different output quantitics when labour varies (with capital constant). The horizontal and vertical patterns like the ones shown in Tuble 10.3 refer to short run changes in production known as return to @ factor). While a pattern of input combinations wherein both the inputs increase or decrease relates to long run changes in production function. If the inputs change in the same proportion, then the pattern of production function would look like a diagonal, i.., output levels 5, 40, 80, 115, 150 and 190 in Table 10.3. Such a pattern is referred to as rerurns to scale, We shall discuss both these kinds of returns in a later Sections of this chapter, If there is an improvement in either the state of technology cr in the managerial ability or both, we get a new production function. This new production function would give a greater flow of output from the original quantity of inputs, or else it would involve smaller quantity of inputs for the original level of output. It must be noted that the form of production function is taken as given by a managerial economist, because formulation of a production function falls, in fact. under the purview of production engineering. 4 ‘managerial economist works only with the given production function. 1.3.4, Short run Analysis of Production Function Before a more detailed analysis of short run production function is undertaken, certain key terms used in ihe analysis must be clarified. These are total product (7P), marginal product (MP) and average product (AP). The total product (7P) is the total amount of output resulting from the use of different quantities of inputs. If we assume labour (L) to be the variable input (capital. K, held constant) then marginal product of labour (UP,)_ is defined as the change in total product (TP) per unit change in variable input, say labour (L), ie., MP, = at . Similarly, average product of labour (4P,) may be defined as total product (TP) per unit of L. TP L \-Law of Variable Proportions. Let us consider a case where all inputs like plant, machinery, floor space, etc., of a firm are fixed, while only the amount of labour services (L) vary. That means that any increase or dlccrease in output is achieved with the help of changes in the amount of L. When the firm changes only the ‘mount of labour, it alters the proportion between the fixed input and the variable input. As the firm keeps on altering this proportion by changing the amount of labour, it inevitably experiences the law of diminishing ‘marginal returns (which is the same thing as the aw of variable proportions). This law states that as more and more of one factor input is employed, all other input quantities held constant, a point will eventually be reached where additional quantities of the varying input will yield diminishing marginal contributions to total SoAP, product To see what happens to the total product in the short run as labour is increased, we may go to Table 10.4 Assume that K is fixed at | unit, while £ increases. Table 10.4 shows that the total product reaches a maximum of 50 when § units of labour are used. The MP of labour for 3rd unit of labour is 10. It then increases to 20, ‘and ultimately becomes negative. Average product of labour also first increases and then falls, ‘Table 10.4. Short-run Production Function: 72 AP and MP. ~~ Variable Input Total Product Marginal Product Average Product ) (TP) (MP) (AP) 0 0 1 5 5 5.00 2 1S 10 7.50 3 35 20 11.67 4 45 10 11.25 5 50 s 10,00 7,50 6 45 _——— 186 Managerial Economics The TE AP and MP and plotted in Fig. 10.5. The stage from where the marginal physical product stars declining shows the law of diminishing returns, or the law of variable proportions. In may be observed that When total product is maximum, MP= 0. Initially, as more units of labour are added to the production process, MP,> AP, When AP, reaches its highest point MP, = AP,, For further unit of labour both 4P; and MP, decline, but while A/P, eventually becomes negative AP, remains positive : The Three Stages of Production. The short-run production function can be divided into three distinet stages of production. We may use Fig. 10.5 to explain these stages. Stage / runs from zero units of variable input to the level where AP of labour is maximum. Stage // follows stage I and then proceeds to the point where MP, of labour is zero (ie., TP; is maximum). Stage /I/ continues on from that point. In Fig. 10.5, Stage I ranges from zero to 3.25 units of labour, Stage II begin from 3.25 units to 5.5 units of labour and Stage IIT lies beyond 5.5 units of labour. It is obvious that no ‘rational’ firm will choose to operate either in Stage I or in Stage III. In Stage I the firm is grossly underutilising its fixed capacity, so in this stage marginal product of variable input rises (i.¢., each additional unit of the variable factor contributes more to output than the earlier units). It is therefore Profitable for the firm to keep on employing additional units of the input. In Stage Ill, the firm grossly coverutilises its fixed capacity. In other words, it would have so little fixed capacity relative to the variable input it uses that the marginal contribution of each additional unit of the variable is negative. It is therefore unadvisable to use any additional unit. Even if cost of variable input is zero, itis still unprofitable to move into Stage III. It can, thus, be concluded that Stage II is the only relevant range for a rational firm in a competitive situation. However, it must be noted that the exact number of labour units hired by the firm within Stage II can be found out only when we have the corresponding data on wage rate. Output 50 40 30 20 Units of Variable Input (Labour) Fig, 10.5. Three Stages of Production Supply and Production Decisions 187 10.3.4. Production Function with Two Va We shall now discuss a more general that are substitutes for exch ees Taha’ Where the firm increases its output by using more of rwo inputs a short-run oF a long-run anglry @bour and capital. The two-varible-input case mey be taken ct nature of firm's inputs, If th a of production process, depending on what assumption is made about the run analysis. While if more aria {wo inputs and both of them are variable, then this a case of long- then this would be taken as a short-run analysis but only two of them are variable (and the others fixed), To illustrate the case of two-variables-inputs te ae ae Urea ee ma Produce 85 units of output, it can do so by employing the following combinations labour and capital is knee ely: (5, 3), (4, 6) and (3, 5). In a graph, the line joining these combinations of and K that give us Q=45 ad Q oo representing 85 units of output (Q). All those combinations of L = 50 have also it i i wre get noguants for ouput Teel gee been aed in Table 10.5. By pling these input combinations lable Inputs ‘Table 10.5. Hypothetical Production Table showing Isoquants Units of labour Output Quantity (Q) oY 6 46 61 80 88 95 86 3 4 3 2 1 Units of Capital (K) Isoquant. An isoquant is a curve representing the various combinations of two inputs that produce the same amount of output. An isoquant is also known as iso-product curve, equal-product curve, or production indifference curve. An isoquant may, therefore, be defined as a curve which shows the different combinations of the two inputs producing a given level of output. Using the data given in Table 10.5 we can construct isoquants or equal product curves. For example, by plotting different combinations of labour and capital required to produce 45 units of good X and then joining these points by a curve, we get an isoquant (Fig. 10.7). We can similarly draw isoquant for every level of output given in Table 10.5. Thus, there will be as many isoquants as the levels of output. In order to distinguish these isoquants we label them with their respective output levels (e.g. 45X, 60X, ete.). ‘Types of isoquants. Isoquants may assume various shapes depending on the degree (or, elasticity) of substitutability of inputs. These shapes are: (1) Linear isoquant. This type assumes perfect substitutability between factors of production, i.e., a given output (say, 50 units) can be produced by using only capital or only labour or by a large number of combinations of capital and labour (Fig. 10.6 a). (2) Input-output isoquant. If we assume strict complementarity (i.e., zero substitutability) between the inputs, we get input-output isoquants. When there is only one method of production for any commodity, its isoquants take the shape of right angle (Fig. 10.6 6). This type of isoquant is also known as the ‘Leontief isoquant’. (3) Kinked isoquant. This assumes limited substitutability of capital and labour. Since there are only a few Managerial Economics 188, Py, P,), substitutability of factors See Py Pay Po oar near programming ; mnt or linear pi Iso called activity analysis isoquat ability of capital and labour only only at kinks (Fig. 10.6 c). This form is als assumes continuous sale vii Such an isoquant appears as ‘cern rage veh ton ent esate fr ea over a certain range, beyond whic! & Smooth curve convex to the origin (Fig. 10.6d) lable for producing any commodity (say, Pi» Units of Capital Units of Capital Isoquant Isoquant a a 0 = Units of Labour Units of Labour (6) Zero Substitutability. (a) Perfect Substitutability Units of Capital Units of Capital Tsoquant : Tsoquant P, vz $804 P, 0 - 0 : Units of Labour Units of Labour (c) Linear Programming Isoquant. (4) Imperfect Substitutability, Fig. 10.6. Types of Isoquants, Itmay be noted that the ki Until at the limit (as 7 : discussion we will andle in practice, tie. wit Puts larger output will result (Fig, re Me AmoUnt of one '™put and the greater (iil) No two isoquants intersect or Louch each other. If ty mean that there willbe a common point on ie 1Wo curves (no: SOgUants i imply that the same amount of labo, ‘UrVES (Point 4 j Fi IT and capital in Fig. 1 is ei here), which is rati 8s station, 2 Produce two level of outputs (eng mon Point (€8,, 60 and 70 units, ionally @ meaningl Supply and Production Decisions 189 Units of Capital Units of Capital \ 60x d 45x on4 aa o ; Units of Labour 3 Units of Labour Fig, 10.7. Higher Isoquant Vs, Lower Isoquant. Fig. 10.8. Non-Intersection of Isoquants. (iv) Isoquants are convex to the origin, The property of convexity implies that the slope of th A 0 lope of the isoquant diminishes from lef to right along the curve, The convexity property of an isoquant can be proved as below. ‘We know that the slope of an isoquant at any point on the curve is the ratio dK/dL, i.e, the units of K required to substitute for each unit of L, so as to keep producing a given level of output. For example, if s . aa = 100 for Q = 500, is implies that if we want to replace 1 unit of L and still produce Q = 500, we must use 160 additional units of K, The ratio dK/dL is called the marginal rate of technical substitution of labour for capital (MRTS,, x). Since, by definition, on an isoquant the output remains constant ‘when dL is substituted for dK, this implies that decrease in output due to decrease in the amount of capital must be compensated by an equal increase in output due to increase in the amount ofllabour. In other words, dK. MP,= dl. MP, where MP, and MPs stand for marginal produetivities of labour and capital respectively (ie, the contribution Sf the last ait of labour and capital respectively to output). The above equation can also be stated as: dK _ MP, MP, 2st ‘MRTS, ,)=——. aL MP, or Slope of isoquant (! LK) MP, We know that as more and more of labour is substituted for capital, each additional unit of labour contrib- utes less and less to output while when capital is reduced cach last unit of capital contributes more and more to output, because relatively inefficient units of labour are coming ito employment while relative inefficient units of capital are going out of employment. Consequently, MP, decreases and MP increases. Thus, when wwe move from left to right on an isoquant (ie., we substitute labour in place of capital), then (MP)/MPx) diminishes. Thus, it is the property of diminishing MATS, x that results in convexity of an isoquant. Tsoquant (or Equal-product) Map. For each evel of output, there isa differentisoquant. When the whole array ofisoquants are represented on agraph, itis called an Isoquant Map (Fig. 10.9). Itshowshow outputs vary as the factor inputs are changed. A higher isoquant represents a higher level of output. However, the distance between any two isoquants does not measure the absolute difference in volume of output they represent. Units of Capital Isoquants 700.X 600 X 500 400%, Units of Labour Fig, 10.9, Isoquant Map. Managerial Economics 190 that the producer operates Economic Region of Production: The Ridge Lines. Economic henry ee ore puree dinar’ SMicient ranges of output. These are the ranges over whic! meenive the methods of production se diminishing but positive. When the marginal products of inputs are negative inputs with negative marginal Considered inefficient. The firm should not, therefore, use comping compensated for the loss due to Products, no matter how cheap they are (unless the firm is somel ae er ilsaamuarre tases inefficiency){The efficient range of output will be represented by the pot See a assert Slope, while the inefficient combinations of inputs are represented uy Bs lee ene ine ae ‘Soquant. Positive slope of an isoquant means that merely to maintain the sar cere seserueaeae ie nctOPe of both the inputs. What is happening in this situation is that the margi a is negative (ce, its additional use will lead to a fall in dutput) so in order Serie tevel. more the other inputs (having positive ‘marginal product) will have to be used. Units of Capital In Fig. 10.10, the upper ) is zero, while the lower Fidge line joins points where marginal product of labour (MP, ae: ae ay giv of output ¢ © pric with the firm for undertaking production Prices of inputs and th Inputs have specific market prices, In ‘letermining the optimal combin take into account the relative prices of inputs some te minimise the cost of words, if firms use more of the relatively cheaper, P Production can be minimised, combinations of inputs 'Y an isocost line, — Supply and Production Decisions I Suppose that the firm wishes to spencsRs. 50,000 on a particular process which involves two factors, labour and capital. Let the price of labour be R3. 100 per unit and of capital Rs. 200 per unit. With Rs. 50,000 the firm can buy either 500 units of labour or 250 units of capital or their combination which fully exhausts Rs. 50,000. A straight line joining 250 units of capital with 500 units of labour will pass through all such combinations of capital and labour which the firm can buy with its outlay of Rs, 50,000, Such a line is called isocost line. To be specific, an isocost line shows various combinations of the factor inputs that the firm can buy with a given outlay and factor prices (e.g. Lo Ky in Fig. 10.11). Every point on an isocost line costs the same to the firm (Rs. 50,000 in our present case). Algebraically, the isocost or the budget line can be expressed as: E=P,L+PyK (10.4) where E= total budget allocation for inputs L and K P, and Px = Prices of labour and capital respectively, Land K = Quantity of labour and capital respectively. Since prices of inputs are taken as constant, the budget line acquires a straight line shape. Slope of the budget line equals relative prices. This can be shown as follows. We know that the budget equation is: E= PLL+PgK 2.4, Or, K= BoP P Thus, slope of the budget line is (2) The Optimal Combination of Inputs Whatever the firm chooses to produce, it wishes to produce it at the least possible cost. Or, whatever expenditure the entrepreneur wishes to make, the highest output with that expenditure is desired. To accomplish either of the two tasks, production must be organised in the most efficient manner, i.e., the resources must be used in an optimal combination. We discuss these two cases below (a) Production of Given Output at Minimum Cost. Suppose that a road transport company wants to fulfil a certain demand for its passenger and cargo services per year. This company is confronted with the following combinations of vehicles and mechanics for producing the desired level of output (Table 10.6). Per year costs of a vehicle and a mechanic are Rs. 1,25,000 and Rs. 3,000 respectively. The problem is: which of the combinations should be used to minimise firm's cost? Table 10.6. Cost Data of Firm X ‘Combination number No. of vehicles ‘No. of mechanics 1 10 1,000 2 i 900 3 12 820 4 13 770 5 14 730 6 15 700 7 16 680 Let us begin with combination 2. An additional vehicle would cost Rs. 1,25,000, but 100 mechanics could be reduced which would save Rs. 3,00,000. So combination 2 is better than combination 1. Similarly, moving from combination 2 to 3 and from combination 3 to 4 would result in some savings. The firm would not move to combination 5 as it does not result in cost reduction; the firm would save Rs. 1,20,000 in mechanics’ salaries but add Rs. 1,25,000 in vehicle expenses. ‘Managerial Economics hhoose an 192 that the firm wishes to cl inputs) hically (Fig. 10.11). SUPP and labour (the oe pir ‘The above analysis can also be shown vim the figure. Given prices o f expenditure. Obviously, to mink output level X;, represented by an ee ae res at different levels . ‘fy on the lowest possib oars Ko boy Kj Ly and Ky La are the different iso duce the desired level of oust Xi on ONY eereasia mise its expenditure the firm will like to ees ee ie i ped our, T ate curve. In the figure, output level X, is pro iisnatpooioto produ the sitce the given level o ine below KL, (eg., that SEE La, are sub-optimal as they de or avhere the isoquant represen ng Risen tne producer's ached point Fi ns the slope ofthe isoquant (5. he at least cost. Equilibrium of the pro. the isocet ne, The angeney means he So oN ee the chosen output is just tangent to the Is the slope ofthe iocost fine (the rao of price CUE Farzal rte of echnical substitution) equals the slope ofthe soc ine Ce nasa abana ee Frasing, while marginal rte of technical revpjoct toa given level of ouput another in purchasing, imize cost the whic these inputs can be substituted in production Thus. 0 ine nwo inputs which equalise the MRTS, cofthe (given input prices) the firm mus purchase those amount ofthe vo inputs which eOWMIETE NTE a ‘inputs to their relative price (w/r), as shown at point E in Fig. 10. (P,/MP). Therefore, equals the ratio of the marginal productivities of the two inputs (viz.. MP)/MP MP, w_ MP, MP, _ MP MRTS 1 =~ = or fa r he optimal combination of inputs wh fora given level of output is L" of labour and i ‘nati jich minimises the cost fora given level K* of capital, as given by the equilibrium point £ in Fig. 10.11. Units of Capital Units of Labour Fig. 10.11, Minimizing cost, given output, (6) Production of Maximum Output with a Given Lt decide about the available expenditure on the production oft consistent with that amount of expenditure, Such a situation is depicted with budgeted expenditure and the input prices, the firm gets an isocost curse output, subject to given resources as represented by the isocost line KL isoquant is tangent to the isocost line. In Fig. 10.12 output level X. is ner level would not be chosen as a higher level of output X can be reach equilibrium level £, OL" of labour and OK" capital are evel of Cost. Alter ‘natively, the firm may first the commo and then try to maximise output the help of Fig. 10.12. Given the KL. The firm wants to maximise This can be achieved where the possible to attain, while X, output d with the given J level of cost. At used to produce X, output Thus, in order to maximise output subject ta given cost the frm must employ inputs in such amounts as to equate the marginal rate of technical substation andthe input pri scar That is, Condition I: Bowl t ok MP, Condition I: MP, supply and Production Decisions 193 Units of Capital Ke Xx, XS 5a 0 x L* L Fig, 10.12. Maximising Output, given resources. Change in Firm’s Resources and Output : The Expansion Path. When a firm’s expenditure on inputs increases (inputs prices remaining the same), it would lead to a parallel shift in the budget line. Each budget line will give a new tangency point and, therefore, a new equilibrium point. If we join these equilibrium points, we get a curve known as expansive path. Thus an expansion path is the locus of different points of equilibrium when the firm’s production expenditure changes, input prices remaining constant. Since it is made up of points of efficient (least cost) combinations of the inputs, the expansion path shows how factor proportions change when output and expenditure change, input prices remaining constant throughout. Construction of an expansion path is explained with the help of Fig. 10.13, where A, B, , 2B, and A;B, are different isocost lines. These isocost or budget lines are parallel to each other as input prices are assumed to remain constant.} Given an isoquant map, each isocost curve will have a corresponding isoquant tangent to it. In Fig. 10.13 these points of tangency are E,, E>, and E,, Each point of tangency implies optimal combination of inputs as well as optimal level of output.‘ At the point of tangency : Units of Labour is often observed that an individual producer has virtually no control on prices 4, For cases of more than two inputs we can prove the result mathematically. Let us write the production function as, DHS Hy Xa Xyerv Me) where Q is the total output and X, are the inputs used in production. Firm's total outlay on inputs is, TC = Py X, +P, X, + +P, X,, where P refers to the prices and subscripts | to n to different inputs. Now, given an output level Q" the firm will minimise its outlay, TC, subject to the constraint of production function, Therefore, set up the following Lagrangian equantion : TC =P,X, + Py Xy + RL ie Xam Xp) ~ 0} Tofind the values of Xj, Xyp..~X, and A which minimise 7C we find the fist derivatives of 7 and equate them to zero : TE avi tnn ax, ax, arc . SS SMX Qu XD 2 By taking fist two eqtions simultaneously, we PP, =~ a/AX, + aX, = MP /MP, We can get similar results for other equations too. Managerial Economics 194 Slope of isoquant = Slope of Isocost line 4 Thats, MRTS,.«= 5 (10.5) or MA " MPx Px Units of Capital Units of Labour Fig, 10,13. The Expansion Path. 7 Joining the various equilibrium points we get an expansion path, P. Equation 10.5 [i.e (MP,JP,) = (Px/P4)] is satisfied for each equilibrium point Ey, Ey, and Ey, Further since the budget lines K, L,, K, L, and X; L; are parallel to each other, (P, /P,) will be the same for all budget lines. It follows from this that (MP, MPs) ot MRTS, x would also be equal at each equilibrium point. Thus, every point on the expansion path must have the same value of the ratio oe or the same MRTS,,y. Changes in Factor Prices and Choice of Technique. Factor prices in ; Production, We know thatthe optimal combination of inputs erat ee oy vonaique a budget line and an isoquant. When price of one ofthe inpure changes, the budget line will spat eon me optimal combination of inputs is found. Obviously, a rayon Producer will like tone wil shift and a new cheaper input in place ofa relatively costly input (whose price Mae ‘actually remained aaa fi ee int but has ecome relatively dearer in relation tothe other input whose price hag fallen). 7 8 change i technique of production. Let us illustrate it with gh he ae 7 factor proportion implies ple. Units of Capital Fic. Inia supply and Production Decisions 195 : with given input prices. The firm is in equilibrium at point L, ie, it Sn eo AG aan ePteented by line OL. Now, when the price of abou fal, the budget line 7 a cheaper (or, cay ital boon primal combination of inputs shits to OM. In other words, as labour bees 7 apis! becomes relatively costlier), the rational producer increases the proportion of labour in production. That is, he shifts his techni i 7 ique of production fror sente os preportin to the one represented by Oh ees from the one represented by OL factor By aparallel shift ofthe new budget line AC, we can observe an important change; when labour becomes cheaper the old output level X, is no more produced by OL factor propertion but by ON factor proportion. \403.5. Long-run Production Function : A Case of Return To Scale " A situation where all inputs are subject to variation is a case of long-run production function, We know that in the short run fixed Inputs set an upper limit to the output because additional units of a variable factor, say labour, are not accompanied by a corresponding change in the fixed factors of production. Consequently, the contribution of the variable inputs declines. By definition, in the long run such limitations do not exist. In the long run, all inputs can change. Let us consider two inputs, labour (L) and capital (K), These can change in two ways : (i) both L and K can change in the same proportion, implying that (K/L) ratio or technique of production remains the same; or (ii) L and K change in different proportion, implying the (K/L) ratio or technique of production varies with change in output. The percentage increase in output when all inputs vary in the same proportion is known as returns to scale. Obviously, returns to scale relate to greater use of inputs maintaining the same technique of production, Where returns td scale occurs, three alternative situations are possible: / |. Constant Return to Scale. Output increases in the sam¢ proportion as the increase in inputs. 2. Increasing Return to Scale. Output increases by a greater proportion than the increase in inputs. 3. Decreasing Returns to Scale, Output increases by a lesser proportion than the increase in inputs. The three kinds of returns to scale can be, jllustrated/with the help of a table and a diagram. Table 10.7 contains the production data of a silicone chip factory/where labour is increased by 1 unit and capital is increased by Rs. 1,00,000 each time. If we refer to colymn (3) of the table we find that labour and capital are proportionately increased by 100%, 50%, 33.33%, 25%, etc., while output does not increase by the same proportion each time, as shown by column (5) of the table. Up to the point where 4 units of labour are employed with 4,00,000 units of capital, we get increasing returns to scale because output increases by a larger proportion than inputs [compare columns (3) and (5)]. For the combinations (5 units of labour, 5,00,000 units of capital) and (6 units of labour, 6,00,000 units of capital), the firm gets constant returns to scale. For the subsequent increases in labour and capital/the firm experiences decreasing returns to scale. ‘Table 10.7. Returr/s to Scale in the Silicone Chips Factory Units of Units of Percentage Total Percentage Returns labour capital increase in product increase in to (Rs.'000) labour and (00 units) total product scale capital _ @ Bw (7 A O. 1 100 - 100 0 2 200 100 220 120 3 300 50 350 59 Increasing a 400 33.33 500 | 429 _ 500 25 625 25 ] 6 600 20 750 20 ‘Constant 7 700 16.66 860 14.66 8 300 14.29 940 93 ] Decreasing 9 900 125 1,000 64 Managerial £COW"""" an which labour and ne proportion move from point I, here. When 10 scale. Between peas does the output. Stion than increase in as are increasing, 6 ing returns to scal he ratio being | ‘than doubles—# 28° inputs increase by Re output inoreases BY 7 et aay cel Fig. 10.15 shows isoquants reflect capital are employed remains constant: 4 to point C we double the output but input less points Cand E there are constant returns to scale Beyond point £ there are decreasing returns to sca inputs. So, the figure shows that spacing of isoquan constant or decreasing. Units of Capital * ‘Scale line Decreasing Returns 800. to Scale [peanennnennenee sp x |coo.x | a Constant Returns to f Seale | | | Increasing Returns to 290. i | Scale Units of Labour 10 18 24 30 36 44 54 68 Fig. 10.15, Returns of Scale. ‘Causes of Increasing Returns to Scale. The reasons for experiencing increasing returns to scale are : (1) In case of large-scale production, work can be divided into small parts indivi i . and e specialisation by handling only one part of the work. 7 oeaceal con aan (2) There are some industries in which itis not possible t 10 und. i blast furnaces, earth moving equipment, etc, rtke production at « small seale, eg.,: (3) In some cases increased size of operation gi gives us some specially for those industries where storage is an important cai en slike sional advantages. This is important chemical industries, cold storage, etc, The advantages of "mass production” have their limits. er nen expansion does not give usany advantage. Rather fer reac operations” as one factor tht tends to produces (1) Coordination and control become increas @2) Information may be lost oF distorted management to lower level management passes in the reverse direction, (204. EMPIRICAL PRODUCTION Fuy, » Potential Forms of Production Funct; may be stated as, a ‘creasing returns 0 scale 4 ingly difficult When osuperyi y from top level . when information CTION n.Recall that _. ‘atin a generalised form a shy O=fL), K Short-run production function or 29K), 7 supply and Production Decisions 197 while the long-run production function may be expressed as, O=fL,K). Ashortrun ae function may take one the following specific forms: Oia (Lin ear) (2) Q=a+bb—cl? (Quadratic) (3) Q-a+bL + cl?— aL (Cubic) aor (4) Q=a+al! (Power function) The shapes of these production functions are shown diagrammatically in Fig, 10.16. In case of a linear function [Fig. 10.16 (a), the total product curve isa straight line with slope b. This situation cannot be widely prevalent because, given fixed quantity of capital, increased use of labour will eventually result in diminishing returns. On the other hand, a quadratic function shows diminishing marginal product (Fig. 10.16 (6)], but it cannot register stage I of short-run production function in which marginal product initially rises. This problem is overcome if we take a cubic function [Fig. 10.16 (c)]. One may represent production function in the form of a power function (Eqn. 4). When represented graphically it would look like Fig. 10.16 (d). As shown in the figure, the shape of the production function depends on the value of 5. Output increases at an increasing rate if b > 1, at a constant rate if b = 1, and at a decreasing rate if b <1. Q 7p or Q 2 | apap foe 1P iP 0 Le Oa ee 0 Lo L MP Fig. 10.16 (a). Linear Production Funetion. Fig. 10.16 (6). Quadratic Production Function. TP) TP 2 ay 2 7P aoe 0 i 70) —>L 0 L > ie > Fig. 10.16 (d). Power Function : Q= a L?. Fig. 10.16 (c). Cubic Production Function. The power function is quite popular with empiricists as it can be transformed into a linear function (when expressed in logarithmic terms). This enables us to use linear regression method for analysis. For example, Power function Q = al! Ke can be transformed into a linear function as: log Q = log a +b log L + clog K If we assume that there are only two inputs, labour and capital, and that both of them are variable, we move to the analysis of Jong-run production function. The power function, thus, can be used to estimate both short-run and long-run production functions. Charles W. Cobb and Paul H. Douglas pioneered and popularised this form of production function. 10,5. EMPIRICAL PRODUCTION FUNCTIONS : STATISTICAL ANALYSIS We may hypothesise several alternative forms of production function, as shown earlier. We will, however, iscuss in detail mainly thetwo most popular production functions viz., the Cobb-Douglas and CES functions. Managerial Economics 198 following form: 10.5.1. Cobb-Douglas Production Function ted by C.W, Cobb, was ofthe The production function, as originally sugges Q= AL’ K" where, Q= total output L= units of labour K = units of capital A =a constant 6 =a parameter. cm Properties of Cobb-Douglas Production Function her ofthese is zero, Q willbe zero. This implies (1) Both L and K should be positive for Q to exist. If eithe that both labour and. capital be combined to get output. + (1-B)) equal I. This means that the function (2) If we look at the parameters we find that their sum [ ( tis discussed in detail later in this chapter. n in the original form assumes constant return to scale. This point is iti id the functional form was rewritten the later version ofthe Cobb-Douglas function, this condition was relaxed an as (10.6) La KS (10.7) ve to scale are constant, When (0. + 8) = I returns > Where (a+ B) could be greater than, equal to or less than 1. sh ‘when (+ B)> I returns to scale are increasing, and when (a+) <1 returns to scale are decreasing. (3) Another important feature of the functio n is that its parameters represent factor-shares in output. In Eqn. (10.7), for example, — Wage share © (otal income * = ental share total income * This is discussed in detail in the following section: (4) We can also find the short-run relations! « and hip of inputs and ou ut (e.g, i (teint ter ct af oar Marginal product of labour (MP,) = ; eet) Marginal product of capital (MPr)=B (OK), (5) Inits Original form, the: ‘Cobb-Dougla; Srumiy (Proof gveninthe following Secresy Tsp int (Ean. 10.6) has the clasticity of substitution of an income policy, portant, Policy implications for. formulation Mathematics of ‘Cobb-Dou 1. The Cobb-Doug! iglas Functions as function is a power fn. fy in a logarithmic form: nection which ca; 2. The original Cobb-Douglas function j, Capital inputs are changed in a certain, © Proper of ‘THs-can be shown as follows," PPOrton gah the, = (10.8) », ut willak IS ‘© Scale, ie., if labour and ° change by the samme proportion 5 apply and Production Decisions ow proof. Let the Cobb-Douglas production function be M a " O= ALY KS : o If inputs increase by a proportion 2 then the new output (Q") would, bi Q*= ALK) : = AMA LRP ALK = 1,9 : (10.9) Ths nee | Cobb-Douglas function has the property of constant returns to scale, i.., output increases bythe same pro cE reer ae a nbuts. Later versions ofthe Cobb-Douglas function relaxed this assumption ints ne » it permitted the possibility of any one of the three cases, viz., increasing, constant and decreasing returns to scale. If (c+ B)> 1 itis case of increasing retu +B)= aims. and if (0+ B) 1 it means output changes by mare than 2 (a case of increasing return). Opposite happens if(cetB)<1 Managerial Economics (a+ B)= lathe elasticity of substitution of 1e we assume that ( sthe only function which satisfies ‘stitution equals unity Or here, And, itis the only is equal (o unity every wh any two factors can be defined as, Proof. We know that cla - ity of substitution betwé juantity ratio (10.13) We know that, MPg_ Py MRS, = E = Me Me” in the elasticity formula (10.13) to get, We therefore, substitute MS in place of factor price rato in d(K/L)+(K/L) oe d( MRS) =(MRS) it f With the help of Eqns. 10.10 and 10.11, we can find the value of MRS. Substituting the value o: “MRS thus derived we get, d(K/L)+(KIL) = 2/B).d( KIL) | = KIL) KIL) =1 © d(a7B).(K7L)+(a/B) (KIL) (a/B)d(KTL) (given that ‘O/B is constant so that it does not affect the derivative). ‘The unitary elasticity of substitution isa famous Property of the Cobb-Douglas function because it assures the relative incom shares of capital and labour are constant for any change in the relative supplies of ital and labour. Thus, it Provides a f factor shares, observed generally that capit rationale for the relative constancy o in the developed countries, 6. Gand B represent the labour ‘and capital shares of output respectively. Proof. Taking logarithm of production function X= AL* KB we get log X= log + o.logl. + B logk + logu. Differentiating log X with respect to log L, we get A(log x) 2ogx) ‘A(logL) ax L L or, an K by kb aux = MP, (10.14) We know that if the labour market is Perfectly competitive, an labour at the going market rate, So the DI From (10.14) and (10.15) we find that a= mp, £ Lo Jek _ wage share PX total income =mp_K Samat, Oe MPa =FecK _ rental share {mn other words, the exponent represents the Fespective fact po total income” Or share of income, Supply and Production Decisions supply ision: 201 7. We oa on Fhe oe bDouglas production function fone ofthe inputs is zero, output is also zero Ifwe © Cobb-Douglas function, we find that it is a multiplicative in nature. In such a function if one input takes the value zero the output becomes zero. It implies that all the inputs considered in the function are necessary for the production process to take place, Importance of Cobb-Douglas Production Function We know that Cobb-Douglas production function is this are many: (1) The Cobb-Douglas function is convenient for international and interindustry comparisons. Since a and B (which are partial elasticity coefficients) are pure numbers (i, independent of units of measurement) they can be easily used for comparing results of different ‘samples having varied units of measurement. (2) Another advantage is that this function captures the essential non-linearities of production process and also has the benefit of the simplification of calculations by transforming the function into a linear form with the help of logarithms. The log-linear function becomes linear in its parameters, which is quite useful to a managerial economist for his analysis, (3) Inaddition to being elasticities, the parameters of Cobb-Douglas function also possess other attributes For example, the sum of (« + B) shows the returns to scale in the production process; cand B represent the labour share and capital share of output respectively, and so on. (4) This function can be used to investigate the nature of long-run production function, viz, increasing, constant and decreasing returns to scale, (5) Although in its original form, Cobb-Douglas production function limits itself to handling just two inputs (e.g., L and K), it can be easily generalised for more that two inputs, like PGi 0 Ades aoe (10.16) where Q is the output and X;, X;,... X, are different inputs. ‘most popular in empirical research. The reasons for Limitations of Cobb-Douglas Production Function Empiricists have found the following limitations with the Cobb-Douglas production function: |. In real life we find that an increase an input (keeping other inputs constant) gives us initially increasing, then constant and lastly diminishing marginal returns. The original Cobb-Douglas function cannot show the marginal product of an input (say, labour) to go through these three stages. It shows mainly the diminishing ‘marginal product case. 2. This function assumes constant returns to scale, which is not possible in general. Certain factors of production cannot be increased in the same proportion, e.g., entrepreneurship. Even if it is possible to do so, itis not usual to find constant returns to scale in the long run. 3. There is the usual problem of measurement of capital. We know that labour is measured in terms of labour services per hour. With respect to capital, it is quite difficult to measure capital services per hour as it involves depreciation over time. 4, Since the raw material does not figure on the input side, the output side is therefore taken as:the net of Taw material (which is known in economic terminology as ‘value-added’). Once we assume constant returns ‘scale, we believe that there is a fixed relation of raw materials (e.g. fuel) and output. 5. The function assumes that there is perfect competition in the factor market. But when we drop this ®ssumption (to make the analysis more realistic), we find that cand B no longer represent factor shares. Given limitations of Cobb-Douglas production function, economists have suggested some alternative Production functions. Constant Elasticity of Substitution (CES) Production function or Homohighplagic Production Function is another alternative. But despite its limitations the Cobb-Douglas Production Function Still remains the most popular among the empirical researchers.

You might also like