PRODUCTION ANALYSIS

1. PRODUCTION FUNCTION:
1.1: PRODUCTION ANALYSIS:
MEANING AND DEFINITION OF PRODUCTION
Production analysis or theory of production deals with a relationship between
input factors and output the operational efficiency for optimum output and cost
of production is not considered.
ACCORDING TO JAMES BATES AND J.R. PARKINSON,” production is the
organized activity of transforming resources into finished products in the form of
goods and services and the objective of production is to satisfy the demand of
such transformed resources”.
1.2: FACTORS OF PRODUCTION:
Production requires the use of certain resources. Each particular resource may be
called a factor of production. Anything that contributes towards output is a factor
of production. For the sake of convenience it is usual to group all productive
resources fewer than four heads land labor capital and organization each group
being called a factor of production.

1. LAND:
• The term is used in different sense in economics.
• It does not mean soil or earth’s surface alone but refers to all free gift of
nature which would include besides the land in common parlance
natural resources fertility of soil water air natural vegetation etc.
2. LABOUR:
• The term labor means mental or physical exertion directed to produce
goods or services.
• In other words it refers to various types of human effort require the use
of physical exertion skill and intellect.
• Labor to have an economic significance must be one which is done with
the motive of some economic reward. Division of labor is an important
feature of modern industrial organization.
 3. CAPITAL:
• Capital may be defined as that part of wealth of an individual or
community which is used for further production of wealth.
• In fact capital is a stock concept which yields as produced means of
production.
4. ENTREPRENEUR:
• It is the factor which mobilizes the other factors land, labor, and capital;
combines them in the right proportion then initiates the process of
production and bears the risk involves in it.
• This factor is known as the entrepreneur. He has also been called the
organizer, the manager or the risk taker.
1.3 PRODUCTION FUNTION:
• Production function states the relationship between inputs and output
i.e., the amount of output that can be produced with given quantities of
inputs under a given state of technical knowledge.
• The output takes the form of volume of goods or services and the inputs
are different factors of production i.e., land, labor, capital and enterprise.
Mathematically the production function is described as,
Q = f (X1, X2, X3 ………Xn)
Where,
Q = Quantity produced during a given period of time
(X1, X2, X3 ……..Xn) = Quantities of various inputs used in production. Production
function can also be defined in a different way. If shows the minimum quantities
of various inputs that are required to yield a given quantity of output.
1.4: ASSUMPTIONS OF PRODUCTION FUNCTIONS
The production function has following assumptions,
1. Perfect divisibility of both inputs and output
2. Limited substitution on one factor for the other.
3. The level of technology remains constant
4. Inelastic supply of fixed factors in the short run
 5. It is related to specified period of time.

1.5: SIGNIFICANCE OF PRODUCTION FUNCTIONS

Production function analysis is of practical importance in managerial decision

making in business.
Some of its managerial uses are given below,
1. Production function analysis is of great of help in making shot period
decisions by business executives in two ways.
a. How to get optimum level of output from a given set of inputs
b. How to get the given level of output from the minimum set of
inputs.
2. Production function analysis is of highly useful in making long period
decisions by business executives If returns to scale are increasing it will be
worthwhile to increase production if returns to scale are diminishing it will
be worthwhile to decrees production and if returns to scale remain
constant it would be indifferent to the producer whether to increase or
decrease production if demand is no constraint.
3. Production function analysis is of great use to calculate the least cost
combination of various factors in outs for a given level of output or the
maximum output input combination for a given cost.
4. Production function analysis is logical and also to common sense if the price
of one factor input falls while one for the second.
5. Production function analysis is of great importance in making decision on
the utility of employing a variable input in the production process.
1.6: LIMITATIONS OF PRODUCTION FUNCTIONS
Production function analysis has the following limitations.
1. Production function analysis has restricted itself to the case of two inputs
and one output. Mathematically, there is no great difficulty in extending
this analysis to multiple inputs and outputs.
 2. Production function analysis has assumed smooth and continues curves
while in the real world, discontinuities in the production function may
appear.
3. Production function analysis assumes that technology remains constant.
But in reality it does not remain the same.
4. Production function analysis is also applied under perfectly competitive
market situations which are rare in the real world.
5. Production function analysis assumes that units of labor are homogeneous.
In reality labor units are not identical but heterogeneous in characters.
2. ISOQUANTS AND ISOCOSTS:
2.1: MEANING AND DEFINITION OF ISOQUANTS
• Isoquant is also known as production function with two variable inputs or
equal product curves
DEFINITION:
According to FERGUSON, an isoquant is a curve showing all possible combinations
of inputs physically capable of producing a given level of output.
• The combinations of all variable inputs which can yield the same output
with various combinations are termed as isoquants.
• They are also known as iso-product or iso-product curve. For better
understanding of isoquants following schedule may be seen which gives
various combinations of variable factors x and y for a given level of output.
factors x and y for a given level of output.
Table 3.2: combination of two inputs
Factor combination Factor X Factor Y
A 1 12
B 2 08
C 3 05
D 4 03
E 5 02
Each of the factor combinations A, B, C, D and E represents the same levels of
production say 100 units. When we plot them we get a curve IQ as shown in
figure 3.3

2.2: ASSUMPTIONS OF ISOQUANTS

Isoquant analysis is normally based on the following assumptions
1. It has been assumed that there are only two factors of input for
geometrical representation but in practice there are generally four or five
or even more variable used in production.
2. It has been assumed that factors of production are divisible in small units
and can be used in various proportions. In practice it not feasible for all
factors.
3. Technology constraints do not permit to change the input variables at any
point of time.
4. During production utmost care is taken to utilize the different factors in
most efficient way. This practice has not been followed in this assumption.
2.3: TYPES OF ISOQUANTS
Isoquants assume different shapes depending upon the degree of
substitutability of inputs under consideration.
1. LINEAR ISOQUANTS:
• In this case the inputs are replaceable in direct proportion. For example,
a given amount of output say 200 units can be obtained by using 2 units
of labor or 1000 units of capital or 4 units of labor and 500 units of
capital. It can have various combinations.
• One more example say a particular village can be electrified by use of
coal or solar power. The desired amount of electricity can be generated
by use of coal or by solar cell. The amount of power generated (say P1,
 P2, P3 ……P5) can be increased by increasing the consumption of coal or
increasing the installed capacity of solar cells. These two are substitute
of each other. Hence in such cases the isoquants are straights lines as
shown in,

2. RIGHT-ANGLE ISOQUANTS:
• In such cases there cannot be any substitutability between the inputs. For
example for plastering of a room requires 2 units of sand and 1 unit of cement
there is no other way to substitute cement by sand (with no quantity
compromise) and for increase in number of rooms of same size the quantity
requirements of sand and cement will increase in the same proportion. This is
called Leontief or inputoutput isoquants as shown in figure 3.5
 3. CONVEX ISOQUANT:
• In this case the substitution of inputs is not in totality. A particular
assignment can be completed by employing minimum labor L1 in time
T1. This assignment can still be completed in shorter periods T2 and T3
by employing more labor i.e. L2 and L3. Increase in labor reduces the
completion time from T1 to T2 and T3.
• To reach level of T3 required a significant increase in labor. Thus the
substitutability of labor for time increases from L1 to L2 to L3.
Further increase in labor has no benefit of time rather it is a waste. This
is shown in figure 3.6.

2.4: GENERAL PROPERTIES OF ISOQUANT CURVES:

The properties of isoquants are describes below
1. ISOQUANTS AE NEGATIVELY SLOPED: Generally isoquants sloe downwards
in anticlockwise direction and follow a negative slope. This is due to the fact
that reduction of one input factor requirements appropriate increase in
other factor for maintaining the same level of output.
 Figure3.7: isoquant having positively-sloped segments
2. HIGHER ISOQUANT REPRESENTS A LARGER OUTPUT: the higher isoquant is
one which can yield higher output by use of same amount of one factor and
higher amount of other factor or higher amount of both the factors.

Figure 3.8: two isoquants representing different output levels.

3. TOW ISOQUANTS INTERSECT OR TOUCH EACH OTHER: since isoquants
represents different level of output and hence they do not intersect or
touch each other.
4. ISOQUANTS ARE CONVEX TO THE ORIGIN: generally in production
processes substitutes can be arranged such as labor can be substituted by
capital and vice versa. However the marginal rate of substitution has a
decreasing tendency.

Figure: convexity of an isoquant

2.5: ISOCOSTS:
• Iso-cost curve is the path traced by several combinations of L and K where
each of them requires the same amount of money for production.
• On differentiating the equation with respect to L we get dK/dL = -w/r, that
represents the slope of the iso-cost curve.
• Iso-cots line represents the various combination of labor and capital which
an industry can use for a given factor price.
• The slop of this online is a ratio dK/dL indicates the factor price. It will shift
towards right when money spent on variable factors increases. SLOPE OF
ISO-COST LINE
• It is clear that with variation of factors i.e., labor and capital the slope of
the cost line can be varied. If the price of the labor decreases then more
labor can be employed and this will make a shift of cost line away from the
origin.
 • However the slope is the resultant of price of the variable of price of the
variable factors and the money spent by the organization.
• If the price of the variable factor remains fixed the iso-cost lines will shift
but the slope of cost line will remain unchanged.

2.6:OPTIMUM COMBINATION OF INPUTS

When producers use the optimal combination of two factors i.e., labor cost and
capital cost to earn maximum profit then it is called optimum combination of
inputs.

The producer has two options to follow,

1. Expend minimum cost for a given output.
2. Achieve maximum output for a given cost.
2.7: OPTIMISATION OF TWO INPUTS
• In the theory of production the profit maximization firm is in equilibrium
when given the cost-price function it maximizes its profits on the basis of
the least combination of factors.
• To achieve this stage a selection has to be made for that set of combination
which provides minimum cost for a given output.

3. PRODUCTION FUNCTION WITH ONE VARIABLE INPUT RETURNS

TO FACTOR
3.1: MEANING AND DEFINITION RETURNS TO FACTORS/LAW OF VARIABLE
PROPORTIONS
• Return to factors is known as the law of available proportions or production
function with one variable.
• In short period of time during production the technical conditions remain
unchanged and it implies that for a specified output the input factors
proportions remain unchanged.
• However it is possible to increase one of the input factors for having
increased output while maintaining the other input factors as constant.
DEFINITION:
According to F. BENHA, as the proportion of one factor in a combination of
factors is increased after a point first the marginal and then the average product
of that factor will diminish.
3.2: ASSUMPTIONS OF LAW OF VARIABLE PROPORTIONS
The law of diminishing returns is based on the following assumptions
1. Only one factor is varied and others are kept fixed
2. It is assumed that factors which are variable are same in all respect and
there are no variations.
3. There is no change in technology
4. The proportions of inputs can be varied
5. This is applicable for short period only I long terms all factors are variable.
6. Due to fall and rise in price of the product the returns in terms of money
may decrease or increase irrespective of output which is measured in
physical quantities like tones quintals.
3.3: TOTAL AVERAGE AND MARGINAL PRODUCT
Before discussing the relationship it is important to understand the
following terms
1. TOTAL PRODUCTION: It is the resultant output of all input factors at any
given time.
 2. AV ERAGE PRODUCTION: the average product is one which is obtained at
the expense of per unit of input factor. It is shown in column 3 of the table
given below. The increase in input variable increases the average product
till it reaches to maximum level and further increase in input variable
results in decrease in average product.
3. MARGINAL PRODUCTION: it is the change in total product due to per unit
change in input variable factor. In other words it is the increase in total
production with per unit increase in input.
3.4: THREE STAGES OF LAW OF VARIABLE PROPORTIONS These
stages are described below
STAGE-1: LAW OF INCREASING RETURNS
The variation characteristics of total product marginal product, and average
product are indicated with variation of labor. The total product marginal product
and average product increases till point 1 is reached. After this stage although
total product rises but rate of increase is reduced considerable.

REASONS FOR INCREASING RETURNS TO A FACTOR

Main reasons of the applications are as under
1. UNDER-UTILISATION OF FIXED FACTOR: in the beginning of the production
some factors remain unutilized /underutilized and with increase in variable
factors these are fully utilized these results in i9ncrease in output.
2. INDIVISIBILITY FACTOR: Due to technological constrains certain factors
remain indivisible and are required to reach a minimum level of that input
 to run the industry irrespective of the output level. The output can be
enhanced with inclusion of other variable factors.
3. SPECIALISATION AND DIVISION OF LABOR: increase in variable factors
increases the
Possibility of division of labor which generates specialization of labor
increase in efficiency and output.
STAGE-2: LAW OF DIMINISHING RETURNS: the total product keep on increasing
with diminishing rate and it reaches to maximum point M, where the second
stage ends. In this stage the average and marginal product also fall but marginal
product falls at faster rate than average product rate. This is a very important
stage since industries are needed to operate at this stage as well.
REASONS FOR LAW OF DIMINISHING RETURNS
The reasons are described as below 1.
CERTAIN FACTORS REMAIN FIXED:
• The four factors such as land labor capital and enterprise cannot be
increases at any point of time.
• But obtaining a higher rate of production it is required that the factor of
production increased at higher rate. Due to constraints it is not possible
to increase these production factors any more.
• This may bring new competitors who may adversely affect the business.
2. CERTAIN FACTORS BECOME SCARCE:
• Sometimes factors like land labor or specially trained labor and capital
become scarce and cannot be increased any further.
• This will adversely affect the output rate of the organization.
3. LACK OF PERFECT SUBSTITUTION OF PRODUCTION FACTORS:
• During production process some factors become short in supply and
producers are forced to use substitutes which are also not always
available. This results in decreasing in output.
4. ACHIEVEMENT OF OPTIMUM CAPACITY:
 • After optimum utilization of all factors in production and utilization of
full plant capacity a saturation point is reached beyond that the output
cannot be increased any further.
IMPORTANCE OF THE LAW OF DIMINISHING RETURNS
Law of diminishing returns has a great importance in economics. This can be
understood by following points,
1. Universal
2. Basis of the theory of population
3. Basis of theory of rent
4. Basis of theory of distribution
5. Basis of optimum production
STAGE-3: LAW OF NEGATIVE RETURNS: at this stage there is a decline in all
respect i.e., total product marginal product and average product. This stage is
termed as stage of negative returns.
REASONS FOR LAW OF NEGATIVE RETURNS
1. REDUCTION IN VARIABLE FACTOR: in such condition the quantity or
number of variable factor is in excess obstruct the movement of other fixed
factors resulting in reduction of output. The reduction in quantity or
number of variable factor is the right choice in such condition.
2. MOVING BEYOND OPTIMUM LEVEL: when the plant has reached at a level
where all inputs are being utilized to the maximum limit the further
movement will result in under utilization of inputs. This will results in
decreased efficiency and losses.

4. COBB-DOUGLAS PRODUCTION FUNCTION

CHARLES W. COBB AND PAUL H. DOUGLAS studied the relationship of inputs and
outputs and formed an empirical production function popularly known as COBB-
DOUGLAS production function. Originally C-D production function applied not to
the production process of an individual form but to the whole of the
manufacturing production.
The COBB-DOUGLAS production is expressed by
Q = AL
Where Q = output
L and K = inputs of labor and capital respectively.
A and = positive parameters where
The equation tells that output depends directly on L and K and that part of
output which cannot be explained by L and K is explained which the residual is
often called technical change.
The marginal products of labor and capital are the functions of the parameters
A and the ratios of labor and capital inputs i.e.,
The two parameters and taken together measure the degree of the homogeneity
of the function. In other words this function characterizes the returns to scale
thus.
a. Increasing returns to scale
b. Constant returns to scale
c. Decreasing returns to scale.

4.1 PROPERTIES OF COBB-DOUGLAS PRODUCTION FUNCTION

The COBB-LOUGLAS production function has the following properties,
1. There are constant returns to scale
2. Elasticity of substitution is equal to one.
3. And represent the labor and capital shares of output respectively.
4. And are also elasticity of output with respect to labor and capital
respectively.
5. If one of the inputs is zero, output will also be zero.
6. The expansion path generated by C-D function is linear and it passes
thro9ugh the origin.
7. The marginal product of labor is equal to the increase in output when the
labor input is increased by one unit.
8. The average product of labor is equal to the ratio between output and
labor input.
 9. The ratio measures factor intensity. The higher this ratio the more
labor intensive is the technique and the lower is this ratio and the more
capital intensive is the technique of production.
4.2 IMPORTANCE OF COBB-DOUGLAS PRODUCTION FUNCTION
COBB-DOUGLAS production function is most popular in empirical research. The
reasons for this are many,
1. The COBB-DOUGLAS function is convenient for international and
interindustry comparisons. Since and (which are partial elasticity
coefficients) are pure numbers (i.e., independent of units of measurement)
they can be easily used for comparing results of different samples having
varied units of measurements.
2. Another advantage is that this function captures the essential non legerities
of production process and also the benefit of the simplification of
calculation 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. In addition to being elasticity’s the parameters of COBB-DOUGLAS function
also possess other attributes. For examples, the sum of shows the
returns to scale in the production process and present the labor
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 increasing constant and decreasing returns to scale.
5. Although in its original form COBB-DOUGLAS production function limits
itself to handling just tow inputs (e.g., L and K) it can be easily generalized
for more than two inputs like,
Where, Q = Output
X1, X2, X3 …...Xn = different inputs.

4.3: TYPES OF PRODUCTION FUNCTION

The law of production can be studied in three ways, How to
produce
Short run long run

Law of variable proportions analysis Isoquant analysis returns toScale.

1. LAW OF VARIABLE PROPORTIONS ANALYSIS: where quantities of some

factors are kept fixed but the other factors is varied.
2. ISOQUANT ANALYSIS: it is production function with two variable inputs.
3. RETURN TO SCALE ANALYSIS: where quantities of all factors are varied.

5. RETURNS TO SCALE
5.1 MEANING AND DEFINITION OF RETURNS TO SCALE
• It is to be understood that variable and output production can be increased
with the increase in one or more input factors in long term.
• This is also termed as return to scale. This indicates the relationship
between scale of input and corresponding output when all the inputs are
increased in the same ratio.
DEFINITION:
According to PROF. ROGER MILLER, returns to scale refer to the
relationship between changes in output and proportionate changes in all
factors of production.

5.2 ASSUMPTIONS OF RETURNS OT SCALE

Following assumptions are made,
1. All inputs can vary except the enterprise
2. Workers accurately do their assigned work with provided tools
3. There are not technology changes during production
4. There is perfect competition
5. The output product is measured in quantities.
5.3 TYPES OF RETURNS TO SCALE
Following are the types of return to scale
1. Increasing returns to scale
2. Constant returns to scale
3. Diminishing returns to scale
According to the given assumptions with increase in factors of production i.e.,
labor and capital following possibilities will be found
1. Output may increase in same ratio as input factors
2. Output may rise at much higher rate compared to input factors
3. Output may increase in very small proportion to increase in input factors.
It is generally found that the increase in input factors is in fixed proportions then
output increases in following three different phases.
1. INCREASING RETURNS TO SCALE: in this case the output increasing rate is
faster than the increasing rate of input factors. For example if the input
factors are doubled or tripled then the output achieved is more than
double or more than triple. Such situation is termed as increasing returns to
scale.
FACTOR COMBINATIONS TOTAL PRODUCT MARGIANL PRODUCT
(QUANTALS) (QUANTALS) (QUANTALS)
1 2 2
2 6 4 increasing returns
6
3 12
6 constant returns
4 18
6
5 24 4 diminishing returns
6 28 2
7 30

2. CONSTANT RETURN TO SCALE: when the increase in total output exactly

equals to increase in inputs then this situation is termed as constant return
to scale. Such situation makes marginal returns constant. It is evident from
 the table above that for 3rd, 4th and 5th units of sale of production the
marginal returns remain constant at 6th. This stage II is indicated in figure
3.15 where the portion B to C of CD curve remains constant. The portion B
to C is horizontal or parallel to scale of production which indicates constant
return to scale.

Figure: returns to scale

3. DIMINISHING RETURNS TO SCALE: such situation indicates arrival of
saturation stage which does not permit further increases in capacity of
plant. The output increase rate is much less than the increase rate of input
factors of production. This stage of indicated as stage 3 in figure
3.15 which shows a downward trend of returns.
6. ECONOMIES DISECONOMIES OF SCALE
6.1INTRODUCTION
• Important information about the processes of production followed by firm
for manufacturing of goods conveyed by the shape of the long-run average
total cost curve.
• Economies of scale is when output increases leading to declaiming of long-
run average total cost. Similarly when output increases leading to rise of
long-run average total cost, it is known as diseconomies of scale.
6.2:MEANING AND DEFINITION OF ECONOMIES OF SCALE
• . Economies of scale can be referred to the increasing efficiencies notion of
goods production with increasing number of goods produced.
• Average production cost of goods typically diminishes along with additional
production. This is because fixed costs of production are shared over the
additional goods produced.
MEANING OF DISECONOMIES OF SCALE
• Diminishing returns to scale can be observed due to continue expansion of
the firm size. When the firm’s expansion goes beyond level growing
diseconomies can be encountered. Economies of production at large scale
are canceled by these diseconomies leading to a rise in the average
production cost.
• Diseconomies of scale are not produced generally due to technical factors
rather these technical factors more likely to limit the sources of scale
economies.
• In case, inefficiencies are caused because of overlarge size of plant this
situation needs to be avoided. Replication of plant units of smaller size may
solve the problem in such cases.
6.3: KINDS OF ECONOMIES AND DISECONOMIES OF SCALE
Classification of the economics of scale and diseconomies of scale can
be done as follows
1. Internal economies of scale and internal diseconomies of scale and
 2. External economies of scale and external diseconomies of scale.

a)INTERNAL ECONOMIES AND DISECONOMIES OF SCALE

1. Technical economics and diseconomies
2. Managerial economies and diseconomies
3. Commercial economies and diseconomies
4. Financial economies and diseconomies
5. Risk bearing economies and diseconomies

b) EXTERNAL ECONOMIES AND DISECONOMIES OF SCALE

EXTERNAL ECONOMIES AND DISECONOMIES OF SCALE

Cheaper raw material & capital

Equipment
Technological external economies
Development of skilled labor
Growth of ancillary industries
Better transportation and marketing facilities

1. Cheaper raw material and capital equipment.

2. Technological external economies
3. Development of skilled labor
4. Growth of ancillary industries
5. Better transportation and marketing facilities