UNIT-III PRODUCTION ANALYSIS

Introduction and Meaning

Production is a process of using various material and immaterial inputs in order to make
output for consumption. Production process creates economic well-being. In the ordinary
language, the term "production" means rising of crops or making of a physical goods in
factories. For example, if you make ice cream, you will say that you have produced ice- cream
(goods). But from the point of view of Economics, you have not produced any new thing in the
form of ice-cream; rather, you have changed the form of milk, sugar, cream, etc, and thus, have
created the utility. Marshall is right to say, "Man does not produce physical (material) goods;
but when it is said that he produces material goods, in fact, he only creates the utility. Even the
scientists also agree that "Matter can neither be created nor destroyed." Thus, in Economics,
the word "production” is used to imply creation or increasing the utility of a good so that its
value is increased. “Production refers to the creation or addition of value”. It simply transforms
the inputs into output.

Definitions

➢ "Production may be defined as the creation of utilities. Anatol Murad

➢ "Production is the process that creates utility in goods. A.H. Smith

➢ "Production is the creation of value in a commodity."- Thomas

➢ "Production is the creation of economic utility "- Ely

➢ "Production means an increase in the value of a commodity."- Nicholson

➢ "Production is any activity which adds to the value of a nation's supply of goods and
services.” -M.J. UImer

➢ "Production may be defined as the process by which inputs may be transformed into
output" - Robert

Difference between Consumption and Production

Generally, production and consumption are considered to be altogether contrary and

different activities.
 Consumption is the use of utility whereas production is creation of utility. In fact, their
difference is not so fundamental. Both these are two different aspects of the same activity. For
example, when a carpenter makes a chair, he performs an act of production by increasing the
utility of log of wood. But at the same time, he has also consumed the log of wood by using its
utility. Thus, two aspects of the same activity are production and consumption. According to
Prof. Mehta., "When the utility of a good is used for the direct satisfaction of want, it is called
consumption, and its use for the indirect satisfactions of want is called production."

Methods of Creation of Utility

Production or creation of utility can be made by the following methods:

1. Form Utility: If by changing the form of a good, capacity to satisfy wants is created in
it, it is called the form utility. Changing of wheat in the form of biscuit, changing of
wood into furniture are the examples of the form utility. Dalmia Biscuit Company or
Godrej Steel Furniture Company or factories changing the raw materials into goods
create the form utility.
2. Place Utility: Utility is also created by changing the place of goods. It is called place
utility. Collecting of the sand from the riverbank and transporting it to the construction
site or transporting the coal to different parts of the country from the coal-mines are the
examples of place utility. A transporter, railways, shipping companies, and airways
create place utility. So, the function of transporting companies is called production.
3. Time Utility: If by an act of storage of a good for some time its utility increases, it is
called time utility. Storing oranges, apples and other fruits in the cold storages until
their crop season is over and their prices increase, is the example of time utility. Thus
the activities of traders, who make the stock of a commo dity, can also be called
production.
4. Service Utility: If the service of a man satisfies our want, it is called service utility. A
professor's teaching in a class, a lawyer's pleading a case, a tailor's stitching a shirt, are
the examples of the creation of service utility. Therefore, a professor, lawyer or a tailor
are also the producers.
5. Possession Utility: If the change of possession of a good increase its utility, it is called
the possession utility. The utility of a sewing machine is not so great for a dealer in
sewing machines as it is for a tailor. The utility of the machine increases by this change
 of possession. It will be called possession utility. Since traders or retailers are the
creators of this utility, their activity is also called production.
6. Knowledge Utility: When the utility of a good increase by increasing people's
knowledge about that goods, it is called knowledge utility. For example, we come to
know about the qualities of LG washing machine, Lux soap or Forhans tooth paste
through advertisements. We make greater demand for these goods. Thus, advertisers
also help production by creating knowledge utility.
Thus, in order to know whether a man is a producer or not, it is to ensure whether an
increase in utility or value is made by the work done by that man or not. It is essential
that the work-done by anyone must create or increase utility.

Factors of Production

You want to produce wheat. For the production of wheat, you require land, workers,
tractor, tube well, seeds, pesticides, favourable climatic conditions and fertilizer, etc. All these
are called the means of production or inputs. With the help of these, we get the output or
production.

"The sources of services which enter into the process of production are called factors
of production. The factors are broadly classified as land, labour, capital, organisation and
enterprise .M.J. Ulmer

According to Dr. Marshall, "In a sense, only nature and man are the two sources of
production-" Benham has rightly remarked, "Factors of production are neither two nor four
but millions." But according to modem economists and for the sake of simplicity, there are four
factors of production namely: (i) land (ii) labour (iii) capital (iv) organisation and enterprise.
Modem economists call all these factors as Input or resources, as under;
 1. Land: Land is that factor of production which is freely available from nature. In it, not
only on the surface of soil is included, but also all other free gifts of the nature below
the surface and above the surface are included; for example, forests, minerals, fertility
of soil, water, etc. According to Marshall, "Land means the material and the forces
which nature gives freely for man's aid, in land and water, in air, light and heat." Land
is also called a natural resource.
2. Labour: Labour is a human factor of production. In it all those mental and physical
activities of man are included which are performed in order to earn money. The services
of a carpenter, black-smith, weaver, teacher, lawyer and doctor, etc., are called labour.
3. Capital: Capital is that man-made factor of production which is used for more
production. Factors like machines, tools, raw materials, buildings, railways, factories,
etc., are called capital. The saving of a man when invested to earn will also be called
capital.
4. Entrepreneur/ Organisation: An entrepreneur is a person who brings other factors of
production in one place. He uses them for the production process. He is the person who
decides what to produce, where to produce and How to produce. A person who takes
these decisions along with the associated risk is an entrepreneur. The payment for
organisation is profit.
The four factors of production in cooperation with one another produce annually a net
aggregate of commodities, material and non-material. This we name as national income. The
national income is to be shared among the four factors of production which have contributed
to this production.
 PRODUCTION ANALYSIS

"Production analysis" is a term used in economics and business to refer

to the study and evaluation of the processes involved in producing goods or
services. It involves analyzing various aspects of production such as input
factors (e.g., labor, capital, materials), production techniques, efficiency,
productivity, costs, and output levels. The goal of production analysis is
typically to optimize production processes, improve efficiency, minimize costs,
and maximize output.

Key components of production analysis may include:

1. Input Analysis: This involves examining the inputs required for

production, such as labor, capital (machinery, equipment), raw
materials, energy, and technology. Input analysis assesses the quantity
and quality of inputs necessary to produce a given level of output.
2. Production Functions: Production functions represent the
relationship between inputs and outputs in the production process.
They can be used to analyze how changes in input levels affect output
and to determine the most efficient combination of inputs to achieve a
desired level of output.
3. Efficiency Analysis: Efficiency analysis involves evaluating how
effectively inputs are being utilized in the production process. This
includes analyzing factors such as technical efficiency (how well inputs
are transformed into outputs), allocative efficiency (the optimal
allocation of inputs to maximize output), and economic efficiency
(minimizing costs for a given level of output).
4. Cost Analysis: Cost analysis examines the costs associated with
production, including fixed costs (costs that do not vary with output),
variable costs (costs that vary with output), total costs, average costs,
and marginal costs. Cost analysis helps identify areas where costs can
be reduced or controlled to improve profitability.
5. Output Analysis: Output analysis involves evaluating the quantity
and quality of goods or services produced by the production process.
 This includes analyzing factors such as production levels, product
quality, customer satisfaction, and market demand for the output.
6. Productivity Analysis: Productivity analysis measures the efficiency
of production by comparing output to input levels. It helps assess the
effectiveness of production processes over time and identify
opportunities for improvement.

Overall, production analysis plays a crucial role in decision-making for

businesses and policymakers, helping to inform strategies for increasing
efficiency, reducing costs, and optimizing resource allocation in the
production of goods and services.
 Unit - II PRODUCTION FUNCTION

The Production Function shows the relationship between the quantity of output and
the different quantities of inputs used in the production process. In other words, it means, the
total output produced from the chosen quantity of various inputs. Generally, production is the
transformation of raw material into the finished goods. These raw materials are classified as
land, labour, capital or natural resources. These may be fixed or variable depending upon the
nature of the business. This function establishes the physical relationship between these inputs
and the output. The efficiency of this relationship depends on the different quantities used in
the production process, the quantities of output and the productivity at each point.

It can be shown algebraically: O = f (I1, I2, I3, I4…….. Zn )

Where, O = quantity of output

I1, I2, I3 = Quantity of different inputs

➢ To quote Samuelson, "The production function is the Technical relationship telling the
maximum amount of output capable of being produced by each and every set of
specified inputs. It is defined for a given set of technical knowledge."

➢ According to Stigler, "the production function is the name given to the relationship
between the rates of input of productive services and the rate of output of product. It is
the economist's summary of technical knowledge.

It can be classified on the basis of the substitutability of the inputs by other inputs:

1. Fixed Proportion Production Function

 2. Variable Proportion Production Function

3. Linear Homogeneous Production Function

4. Cobb. Douglas Production Function

5. Constant Elasticity of Substitution

Thus, it is a comprehensive function that involves different activities ranging from the
production of output from the given inputs and its distribution by the marketing division of the
organization.

1. Fixed Proportion Production Function

The Fixed Proportion Production Function, also known as a Leontief Production

Function implies that fixed factors of production such as land, labour, raw materials are used
to produce a fixed quantity of an output and these production factors cannot be substituted for
the other factors. In other words, fixed quantity of inputs is used to produce the fixed quantity
of output. All the factors of production are fixed and cannot be substitu ted for one another.
Suppose there are 50 workers required to produce 500 units of a product, then the technical
Coefficient of production will be 1/10. In the case of a fixed proportion production function,
this one tenth of labour must be employed for the production of fixed output and no other
factors of production can be substituted in place of labour.

The concept of fixed proportion production function can be further understood with the
help of a figure as shown below:
 In the given figure, OR shows the fixed labour-capital ratio, if a firm wants to produce
100 units of a product, then 2 units of capital and 3 units of labour must be employed to attain
this output. Similarly, for the production of 300 and 500 units of a product, 5 units of capital
and 6 units of labour and 7 units of capital and 9 units of labour must be employed respectively.
It may be noticed that along the isoquant curve the marginal product of a factor is zero, lets
say, for the production of 300 units of a product, the capital is fixed (say 5 units), then any
additional units of a labour won’t make any difference in the total production, hence, the
marginal product of labour is zero.

2. Variable Proportion Production Function

The Variable Proportion Production Function implies that the ratio in which the factors
of production such as labour and capital are used is not fixed, and it is variable. Also, the
different combinations of factors can be used to produce the given quantity, thus, one factor
can be substituted for the other. In the case of variable proportion production function, the
technical Coefficient of production is variable, i.e. the required quantity of output can be
achieved through the combination of different quantities of factors of production, such as these
factors can be varied by substituting other factor/ factors in its place.

Suppose 40 workers are required to produce 200 units of a product, then technical
Coefficient of production will be 1/5. In the case of a variable proportion production function,
one fifth of labour is not necessarily to be employed, but however, the different combinations
of factors of production can be used to produce a given level of output. Thus, the labour can be
substituted for any other factors.

The concept of variable proportion production function can be further understood from an
isoquant curve, as shown in the figure below:
 In the figure, the isoquant curves show that the different combinations of factors of
technical substitution can be employed to get the required amount of output. Thus, for the
production of a given level of product, the input factors can be substituted fo r the other.

3. Linear Homogeneous Production Function

The Linear Homogeneous Production Function implies that with the proportionate
change in all the factors of production, the output also increases in the same proportion. Such
as, if the input factors are doubled the output also gets doubled. This is also known as constant
returns to a scale. The production function is said to be homogeneous when the elasticity of
substitution is equal to one. The linear homogeneous production function can be used in the
empirical studies because it can be handled wisely. That is why it is widely used in linear
programming and input-output analysis.
This production function can be shown symbolically:

nP = f (nK, nL)

Where,

n=number of times
nP = number of times the output is increased
nK= number of times the capital is increased

nL = number of times the labour is increased

Thus, with the increase in labour and capital by “n” times the output also increases in
the same proportion. The concept of linear homogeneous production function can be further
comprehended through the illustration given below:
 In the case of a linear homogeneous production function, the expansion is always a straight
line through the origin, as shown in the figure. This means that the proportions between the
factors used will always be the same irrespective of the output levels, provided the factor prices
remains constant.

4. Cobb-Douglas Production Function

The Cobb-Douglas Production Function, given by Charles W. Cobb and Paul H. Douglas
is a linear homogeneous production function, which implies, that the factors of production can
be substituted for one another up to a certain extent only. With the proportionate increase in
the input factors, the output also increases in the same proportion. Thus, there are constant
returns to a scale. In Cobb-Douglas production function, only two input factors, labour, and
capital are taken into the consideration, and the elasticity of substitution is equal to one. It is
also assumed that, if any, of the inputs, is zero, the output is also zero.

Likewise, in the linear homogeneous production function, the expansion path generated by
the cobb-Douglas function is also a straight line passing through the origin. The CD function
can be expressed as follows:

Q = ALαKβ

Where,
Q = output
A = positive constant
K = capital employed
L = Labour employed
α and β = positive fractions show the elasticity coefficients of outputs for inputs labor
and capital, respectively.
Β = 1-α

This algebraic form of Cobb-Douglas function can be changed in a log linear form, with
the help of regression analysis:

Log Q = log A + α log L + β log K

The homogeneity of the Cobb-Douglas production function can be checked by adding the
values of α and β. If the sum of these parameters is equal to one, then it shows that the
production function is linearly homogeneous, and there are constant returns to a scale. If the
sum of these parameters is less or more than one, then there is a decreasing and increasing
returns to a scale respectively.

5. Constant Elasticity of Substitution Production Function

The Constant Elasticity of Substitution Production Function or CES implies, that any
change in the input factors, results in the constant change in the output. In CES, the elasticity
of substitution is constant and may not necessarily be equal to one or unity. The constant
elasticity of substitution production function can be shown algebraically as:

Q = A [ α K – Φ + ( 1 – α ) L – Φ ] -1/ Φ

Where, Q = output, K = Capital and L = Labour

A = efficiency parameter that shows the organizational aspects of production and the
state of technology. The Constant elasticity of substitution production function shows,
that any change in the technology or organizational aspects, the production function
changes with a shift in the efficiency parameter.

α= distribution parameter or capital intensity factor coefficient concerned with relative

factors in the total output.

Φ = substitution parameter, that determines the elasticity of substitution

The homogeneity of the production function can be determined by the value of the
substitution parameter (Φ), if it is equal to one, then it is said to be linearly homogeneous i.e.
the proportionate change in the input factors results in the increase in the output in the same
proportion.

In constant elasticity of substitution production function, all the input factors are taken
into the consideration such as raw material, technology, labour, capital, etc. The marginal
product of one factor increases with the increase in the value of the other factors of production.
Also, the marginal product of labour and capital will be positive in case of constant returns to
scale.
 UNIT-III - ISO-QUANT AND ISO-COST CURVE

The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant =
quantity or product = output. Thus, it means equal quantity or equal product. Different factors
are needed to produce a good. These factors may be substituted for one another. A given
quantity of output may be produced with different combinations of factors. Iso-quant curves
are also known as Equal-product or Iso-product or Production Indifference curves. Since it is
an extension of Indifference curve analysis from the theory of consumption to the theory of
production. Just as an indifference curve shows the various combinations of any two
commodities that give the consumer the same amount of satisfaction (Iso-utility), similarly an
iso-quant indicates “the various combinations of two factors of production which give the
producer the same level of output per unit of time” “Iso-product or Iso-quant curve”. Like,
indifference curves, Iso- quant curves also slope downward from left to right. An iso-quant is
analogous to an indifference curve in more than one way. In it, two factors (capital and labour)
replace two commodities of consumption. An iso-quant shows equal level of product while an
indifference curve shows equal level of satisfaction at all points. The slope of an Iso-quant
curve expresses the marginal rate of technical substitution (MRTS).

Definitions:
▪ “The Iso-product curves show the different combinations of two resources with which
a firm can produce equal amount of product.” Bilas
▪ “Iso-product curve shows the different input combinations that will produce a given
output.” Samuelson
▪ “An Iso-quant curve may be defined as a curve showing the possible combinations of
two variable factors that can be used to produce the same total product.” Peterson
▪ “An Iso-quant is a curve showing all possible combinations of inputs physically capable
of producing a given level of output.” Ferguson
Assumptions:
The main assumptions of Iso-quant curves are as follows:
1. Two Factors of Production: Only two factors are used to produce a commodity.
2. Divisible Factor: Factors of production can be divided into small parts.
3. Constant Technique: Technique of production is constant.
 4. Possibility of Technical Substitution: The substitution between the two factors is
technically possible. That is, production function is of ‘variable proportion’ type rather
than fixed proportion.
5. Efficient Combinations: Under the given technique, factors of production can be used
with maximum efficiency.

Iso-Product Schedule:
Let us suppose that there are two factor inputs—labour and capital. An Iso-product
schedule shows the different combination of these two inputs that yield the same level of output
as shown in table 1.

The table 1 shows that the five combinations of labour units and units of capital yield
the same level of output, i.e., 200 metres of cloth. Thus, 200 metre cloth can be produced by
combining. (a) 1 units of labour and 15 units of capital, (b) 2 units of labour and 11 units of
capital, (c) 3 units of labour and 8 units of capital, (d) 4 units of labour and 6 units of capital
and (e) 5 units of labour and 5 units of capital.

Iso-Product Curve:
 From the above schedule iso-product curve can be drawn with the help of a diagram.
An. equal product curve represents all those combinations of two inputs which are capable of
producing the same level of output. The Fig. 1 shows the various combinations of labour and
capital which give the same amount of output. A, B, C, D and E.

Iso-Product Map or Equal Product Map:

An Iso-product map shows a set of iso-product curves. They are just like contour lines
which show the different levels of output. A higher iso-product curve represents a higher level
of output. In Fig. 2 we have family iso-product curves, each representing a particular level of
output. The iso-product map looks like the indifference of consumer behaviour analysis. Each
indifference curve represents particular level of satisfaction which cannot be quantified. A
higher indifference curve represents a higher level of satisfaction, but we cannot say by how
much the satisfaction is more or less. Satisfaction or utility cannot be measured.

An iso-product curve, on the other hand, represents a particular level of output. The
level of output being a physical magnitude is measurable. We can therefore know the distance
between two equal product curves. While indifference curves are labelled as IC1, IC2, IC3, etc.,
the iso-product curves are labelled by the units of output they represent -100 metres, 200
metres, 300 metres of cloth and so on.

Properties of Iso-Product Curves:

The properties of Iso-product curves are summarized below:
1. Iso-Product Curves Slope Downward from Left to Right:
They slope downward because MTRS of labour for capital diminishes. When we
increase labour, we have to decrease capital to produce a given level of output. The downward
sloping iso-product curve can be explained with the help of the following figure:

The Fig. 3 shows that when the amount of labour is increased from OL to OL1, the
amount of capital has to be decreased from OK to OK1, the iso-product curve (IQ) is falling as
shown in the figure.
The possibilities of horizontal, vertical, upward sloping curves can be ruled out
with the help of the following figure 4:

(i) The figure (A) shows that the amounts of both the factors of production are
increased- labour from L to Li and capital from K to K1. When the amounts of both factors
increase, the output must increase. Hence the IQ curve cannot slope upward from left to right.
(ii) The figure (B) shows that the amount of labour is kept constant while the amount
of capital is increased. The amount of capital is increased from K to K1. Then the output must
increase. So IQ curve cannot be a vertical straight line.
(iii) The figure (C) shows a horizontal curve. If it is horizontal the quantity of labour
increases, although the quantity of capital remains constant. When the amount of capital is
increased, the level of output must increase. Thus, an IQ curve cannot be a horizontal line.
2. Isoquants are Convex to the Origin:
Like indifference curves, isoquants are convex to the origin. In order to understand this
fact, we have to understand the concept of diminishing marginal rate of technical substitution
(MRTS), because convexity of an isoquant implies that the MRTS diminishes along the
isoquant. The marginal rate of technical substitution between L and K is defined as the quantity
of K which can be given up in exchange for an additional unit of L. It can also be defined as
the slope of an isoquant.

It can be expressed as: MRTSLK = – ∆K/∆L = dK/ dL

Where ∆K is the change in capital and AL is the change in labour.

Equation (1) states that for an increase in the use of labour, fewer units of capital will
be used. In other words, a declining MRTS refers to the falling marginal product of labour in
relation to capital. To put it differently, as more units of labour are used, and as certain units of
capital are given up, the marginal productivity of labour in relation to capital will decline.

This fact can be explained in Fig. 5. As we move from point A to B, from B to C and
from C to D along an isoquant, the marginal rate of technical substitution (MRTS) of capital
for labour diminishes. Every time labour units are increasing by an equal amount (AL) but the
corresponding decrease in the units of capital (AK) decreases. Thus, it may be observed that
due to falling MRTS, the isoquant is always convex to the origin.

3. Two Iso-Product Curves Never Cut Each Other:

As two indifference curves cannot cut each other, two iso-product curves cannot cut
each other. In Fig. 6, two Iso-product curves intersect each other. Both curves IQ1 and IQ2
represent two levels of output. But they intersect each other at point A. Then combination A =
B and combination A= C. Therefore, B must be equal to C. This is absurd. B and C lie on two
different iso-product curves. Therefore, two curves which represent two levels of output cannot
intersect each other.

4. Higher Iso-Product Curves Represent Higher Level of Output:

A higher iso-product curve represents a higher level of output as shown in the figure 7
given below:

In the Fig. 7, units of labour have been taken on OX axis while on OY, units of capital.
IQ1 represents an output level of 100 units whereas IQ2 represents 200 units of output.
5. Isoquants Need Not be Parallel to Each Other:
It so happens because the rate of substitution in different isoquant schedules need not
be necessarily equal. Usually they are found different and, therefore, isoquants may not be
parallel as shown in Fig. 8. We may note that the isoquants Iq1 and Iq2 are parallel but the
isoquants Iq3 and Iq4 are not parallel to each other.
6. No Isoquant can Touch Either Axis:
If an isoquant touches X-axis, it would mean that the product is being produced with
the help of labour alone without using capital at all. These logical absurdities for OL units of
labour alone are unable to produce anything. Similarly, OC units of capital alone cannot
produce anything without the use of labour. Therefore, as seen in figure 9, IQ and IQ1 cannot
be isoquants.

ISO-COST LINE OR OUTLAY LINES

The combination of factor-inputs with which a firm produces output depends upon the
quantity of output that the firm wants to produce. Besides, the combination of factor-inputs
also depends upon the amount of money that the firm wants to spend and prices of the factor-
inputs. An iso-cost line is a graphical representation of various combinations of two factors
(labour and capital) which the firm can afford or purchase with a given amount of money or
total outlay. It is an important tool for determining what combination of factor-inputs the firm
will choose for production process.
 Suppose a producer has Rs. 200 and he wants to spend his entire outlay on two factors
– labour and capital. Further suppose that the price of Labour is Rs. 4 per unit and the price of
capital is Rs 5 per unit. If the firm spends its whole outlay of Rs 200 on labour only, he can
buy 50 units of labour. And, if the firm spends its entire outlay on capital only, then he can buy
40 units of capital.

Mathematically, an iso-cost line can be expressed as

C=wL+rK
Where,
C = cost of production
w = price of labour or wages
L = units of labour
r = price of capital or interest rate
K =units of capital

The iso-cost line is similar to the price or budget line of the indifference curve analysis.
It is the line which shows the various combinations of factors that will result in the same level
of total cost. It refers to those different combinations of two factors that a firm can obtain at
the same cost.
Definition:
Iso-cost line may be defined as the line which shows different possible combinations
of two factors that the producer can afford to buy given his total expenditure to be incurred on
these factors and price of the factors.

Explanation:
The concept of iso-cost line can be explained with the help of the following table 3 and
Fig. 12. Suppose the producer’s budget for the purchase of labour and capital is fixed at Rs.
100. Further suppose that a unit of labour cost the producer Rs. 10 while a unit of capital Rs.
20.
From the table cited above, the producer can adopt the following options:
(i) Spending all the money on the purchase of labour, he can hire 10 units of labour
(100/10 = 10)

(ii) Spending all the money on the capital he may buy 5 units of capital.

(iii) Spending the money on both labour and capital, he can choose between various
possible combinations of labour and capital such as (4, 3) (2, 4) etc.

Diagram Representation:

In Fig. 12, labour is given on OX-axis and capital on OY-axis. The points A, B, C and
D convey the different combinations of two factors, capital and labour which can be purchased
by spending Rs. 100. Point A indicates 5 units of capital and no unit of labour, while point D
represents 10 units of labour and no unit of capital. Point B indicates 4 units of capital and 2
units of labour. Likewise, point C represents 4 units of labour and 3 units of capital.

Shift in Iso-cost Line

An iso-cost line may shift due to two reasons. They are

1. Change in total outlay to be made by the firm

2. Change in price of a factor-input
Change in Total Outlay to be made by the Firm

When the firm decides to increase the total money to be spent on purchase of inputs
while prices of the inputs remain the same, the producer becomes able to afford such
combinations of inputs which were initially unattainable to him. This causes iso-cost line to
shift to a new position higher to the initial line.
Figure: shift in iso-cost line due to change in total outlay

In the above figure, AB is the initial iso-cost line. When the firm increased its total
outlay, the iso-cost line shifted rightwards to a higher position A’B’ where the producer could
purchase combinations of inputs with higher units of labour- and capital. Likewise, if the firm
reduces its total outlay, the iso-cost line will shift leftwards to A”B”. Whether the iso-cost line
shifts toward the left or toward the right, it will always remain parallel to the original line.

It is because the slope of an iso-cost line is calculated as

Since we assume that no changes are made in the prices of either of the inputs, the slope
remain the same for all budget line at any given outlay. And, any lines with same slope are
parallel to each other.
Change in Price of a Factor-Input

When price of factor-input changes, the iso-cost line swings or rotates. The direction in
which the iso-cost line will swing depends upon the factor whose price has changed.

Case I: Change in price of labour

Figure: shift in iso-cost line due to change in price of labour

Let us suppose that a firm has total outlay of Rs. 200 and AB is initial iso-cost line. Let
us also suppose that the price of labour was decreased by certain amount, as a result of which
the producer became able to purchase more units of labour at the same outlay. However, the
producer can’t increase purchasing units of capital as price of capital is constant. Therefore,
the position of price line is changed in the x-axis but unchanged in y-axis.

Simply, decrease in price of labour causes anti-clockwise rotation and increase in price of
labour causes clockwise rotation.

Case II: Change in price of capital

Figure: shift in iso-cost line due to change in price of capital
 Once again, let us assume that a firm has total outlay of Rs. 200 but this time let us
suppose that the price of capital has changed and not of labour. In this case, the producer will
be able to buy more units of capital at same outlay but won’t be able to increase the purchasing
units of labour. As a result, the iso-cost line shifts its position in y-axis and not in x-axis.

In the diagram, we can see that iso-cost line AB shifts to new position A’B as a result of
decrease in price of capital. Likewise, the line shifts to A”B as a result of increase in price of
capital. In other words, decrease in price of capital causes clockwise shift in iso-cost line and
increase in price of capital causes anti-clockwise shift.

EXPANSION PATH
An expansion path provides a long-run view of a firm’s production decision and can be
used to create its long-run cost curves. Since we define long-run as a time period in which a
firm can change all its inputs including capital, the expansion path depends on how the firm
changes its input mix.

As financial resources of a firm increase, it would like to increase its output. The output
can only be increased if there is no increase in the cost of the factors. In other words, the level
of total output of a firm increases with increase in its financial resources. By using different
combinations of factors a firm can produce different levels of output. Which of the optimum
combinations of factors will be used by the firm is known as Expansion Path. It is also called
“Scale-line”.

“Expansion path is that line which reflects least cost method of producing different
levels of output.” Stonier and Hague.
 Expansion path is a graph which shows how a firm’s cost minimizing input mix
changes as it expands production. It traces out the points of tangency of the iso-cost lines and
isoquants. A profit-maximizing firm is interested in producing maximum output at minimum
cost. This occurs at a point at which its iso-cost line is tangent to the relevant isoquant. As the
firm increases its input budget while the unit costs of inputs remain the same, the firm’s iso-
cost lines shift outwards such that they touch higher and higher isoquants. If we connect all
such points at which iso-cost lines are tangent to the isoquants, we get the firm’s expansion
path.

Expansion path can be explained with the help of Fig. 16. On OX-axis units of labour
and on OY-axis units of capital are given. The initial iso-cost line of the firm is AB. It is tangent
to IQ at point E which is the initial equilibrium of the firm. Supposing the cost per unit of
labour and capital remains unchanged and the financial resources of the firm increase.

As a result, firm’s new iso-cost-line shifts to the right as CD. New iso-cost line CD will
be parallel to the initial iso-cost line. CD touches IQ1 at point E1 which will constitute the new
equilibrium point. If the financial resources of the firm further increase, but cost of factors
remaining the same, the new iso-cost line will be GH. It will be tangent to Iso-quant curve IQ2
at point E2 which will be the new equilibrium point of the firm. By joining together equilibrium
points E, E1 and E2, one gets a line called scale-line or Expansion Path. It is because a firm
expands its output or scale of production in conformity with this line.
 Unit-III - LAWS OF PRODUCTION: LAWS OF RETURNS TO SCALE AND
VARIABLE PROPORTIONS

The laws of production describe the technically possible ways of increasing the level
of production. Output may increase in various ways. Output can be increased by changing all
factors of production. Clearly this is possible only in the long run. Thus the laws of returns to
scale refer to the long-run analysis of production. In the short run output may be increased by
using more of the variable factor(s), while capital (and possibly other factors as well) are kept
constant. The marginal product of the variable factors) will decline eventually as more and
more quantities of this factor are combined with the other constant factors. The expansion of
output with one factor (at least) constant is described by the law of (eventually) diminishing
returns of the variable factor, which is often referred to as the law of variable proportions.

We will first examine the long-run laws of returns of scale.

A. Laws of Returns to Scale: Long-Run Analysis of Production:
In the long run expansion of output may be achieved by varying all factors. In the long run all
factors are variable. The laws of returns to scale refer to the effects of scale relationships. In
the long run output may be increased by changing all factors by the same proportion, or by
different proportions. Traditional theory of production concentrates on the first case, that is,
the study of output as all inputs change by the same proportion. The term ‘returns to scale’
refers to the changes in output as all factors change by the same proportion.

Suppose we start from an initial level of inputs and output

X0 = ƒ(L, K)
and we increase all the factors by the same proportion k. We will clearly obtain a new level of
output X*, higher than the original level X0,
X = ƒ(kL, kK)

 If X* increases by the same proportion k as the inputs, we say that there are constant
returns to scale.

 If X* increases less than proportionally with the increase in the factors, we have
decreasing returns to scale.
  If X* increases more than proportionally with the increase in the factors, we have
increasing returns to scale.

Returns to scale and homogeneity of the production function:

Suppose we increase both factors of the function

X0 = ƒ(L, K)
by the same proportion k, and we observe the resulting new level of output X

X* = ƒ (kL, kK)

If k can be factored out (that is, may be taken out of the brackets as a common factor),
then the new level of output X* can be expressed as a function of k (to any power v) and the
initial level of output

X* = Kvƒ (L, K)
or

X* = kvX0
and the production function is called homogeneous. If k cannot be factored out, the
production function is non-homogeneous. Thus A homogeneous function is a function such
that if each of the inputs is multiplied by k, then k can be completely factored out of the
function. The power v of k is called the degree of homogeneity of the function and is a measure
of the returns to scale

 If v = 1 we have constant returns to scale. This production function is sometimes called

linear homogeneous.

 If v < 1 we have decreasing returns to scale.

 If v > 1 we have increasing returns to scale.

Returns to scale are measured mathematically by the coefficients of the production

function. For example, in a Cobb-Douglas function

X = b0Lb1Kb2
the returns to scale are measured by the sum (b1 + b2) = v.
 For a homogeneous production function the returns to scale may be represented
graphically in an easy way. Before explaining the graphical presentation of the returns to scale
it is useful to introduce the concepts of product line and isocline.

Product lines:
To analyze the expansion of output we need a third dimension, since along the two-
dimensional diagram we can depict only the isoquant along which the level of output is
constant. Instead of introducing a third dimension it is easier to show the change of output by
shifts of the isoquant and use the concept of product lines to describe the expansion of output.

A product line shows the (physical) movement from one isoquant to another as we
change both factors or a single factor. A product curve is drawn independently of the prices of
factors of production. It does not imply any actual choice of expansion, which is based on the
prices of factors and is shown by the expansion path. The product line describes the technically
possible alternative paths of expanding output. What path will actually be chosen by the firm
will depend on the prices of factors.

The product curve passes through the origin if all factors are variable. If only one factor
is variable (the other being kept constant) the product line is a straight line parallel to the axis
of the variable factor (figure 3.15). The K/L ratio diminishes along the product line.
Among all possible product lines of particular interest are the so-called isoclines. An isocline
is the locus of points of different isoquants at which the MRS of factors is constant. If the
production function is homogeneous the isoclines are straight lines through the origin. Along
any one isocline the K/L ratio is constant (as is the MRS of the factors). Of course the K/L ratio
(and the MRS) is different for different isoclines (figure 3.16).

If the production function is non-homogeneous the isoclines will not be straight lines,
but their shape will be twiddly. The K/L ratio changes along each isocline (as well as on
different isoclines) (figure 3.17).

Graphical presentation of the returns to scale for a homogeneous production function:

The returns to scale may be shown graphically by the distance (on an isocline) between
successive ‘multiple-level-of-output’ isoquants, that is, isoquants that show levels of output
which are multiples of some base level of output, e.g., X, 2X, 3X, etc.

Constant returns to scale:

Along any isocline the distance between successive multiple- isoquants is constant.
Doubling the factor inputs achieves double the level of the initial output; trebling inputs
achieves treble output, and so on (figure 3.18).
Decreasing returns to scale:
The distance between consecutive multiple-isoquants increases. By doubling the inputs,
output increases by less than twice its original level. In figure 3.19 the point a’, defined by 2K
and 2L, lies on an isoquant below the one showing 2X.

Increasing returns to scale:

The distance between consecutive multiple-isoquants decreases. By doubling the
inputs, output is more than doubled. In figure 3.20 doubling K and L leads to point b’ which
lies on an isoquant above the one denoting 2X.

Returns to scale are usually assumed to be the same everywhere on the production
surface, that is, the same along all the expansion-product lines. All processes are assumed to
show the same returns over all ranges of output either constant returns everywhere, decreasing
returns everywhere, or increasing returns everywhere.

However, the technological conditions of production may be such that returns to scale
may vary over different ranges of output. Over some range we may have constant returns to
scale, while over another range we may have increasing or decreasing returns to scale. In figure
3.21 we see that up to the level of output 4X returns to scale are constant; beyond that level of
output returns to scale are decreasing. Production functions with varying returns to scale are
difficult to handle and economists usually ignore them for the analysis of production.

With a non-homogeneous production function returns to scale may be increasing,

constant or decreasing, but their measurement and graphical presentation is not as
straightforward as in the case of the homogeneous production function. The isoclines will be
curves over the production surface and along each one of them the K/L ratio varies.
In most empirical studies of the laws of returns homogeneity is assumed in order to
simplify the statistical work. Homogeneity, however, is a special assumption, in some cases a
very restrictive one. When the technology shows increasing or decreasing returns to scale it
may or may not imply a homogeneous production function.

Causes of increasing returns to scale:

The increasing returns to scale are due to technical and/or managerial indivisibilities.
Usually most processes can be duplicated, but it may not be possible to halve them. One of the
basic characteristics of advanced industrial technology is the existence of ‘mass-production’
methods over large sections of manufacturing industry. ‘Mass- production’ methods (like the
assembly line in the motor-car industry) are processes available only when the level of output
is large. They are more efficient than the best available processes for producing small levels of
output.
For example, assume that we have three processes:

The K/L ratio is the same for all processes and each process can be duplicated (but not
halved). Each process has a different ‘unit’-level. The larger-scale processes are technically
more productive than the smaller-scale processes. Clearly if the larger-scale processes were
equally productive as the smaller-scale methods, no firm would use them: the firm would prefer
to duplicate the smaller scale already used, with which it is already familiar. Although each
process shows, taken by itself, constant returns to scale, the indivisibilities will tend to lead to
increasing returns to scale.

For X < 50 the small-scale process would be used, and we would have constant returns
to scale. For 50 < X < 100 the medium-scale process would be used. The switch from the
smaller scale to the medium-scale process gives a discontinuous increase in output (from 49
tons produced with 49 units of L and 49 units of K, to 100 tons produced with 50 men and 50
machines). If the demand in the market required only 80 tons, the firm would still use the
medium-scale process, producing 100 units of X, selling 80 units, and throwing away 20 units
(assuming zero disposal costs). This is one of the cases in which a process might be used
inefficiently, because this process operated inefficiently is still relatively efficient compared
with the small-scale process. Similarly, the switch from the medium-scale to the large-scale
process gives a discontinuous increase in output from 99 tons (produced with 99 men and 99
machines) to 400 tons (produced with 100 men and 100 machines).

If the demand absorbs only 350 tons, the firm would use the large-scale process
inefficiently (producing only 350 units, or producing 400 units and throwing away the 50
units). This is because the large-scale process, even though inefficiently used, is still more
productive (relatively efficient) compared with the medium-scale process.

Causes of decreasing returns to scale:

The most common causes are ‘diminishing returns to management’. The ‘management’
is responsible for the co-ordination of the activities of the various sections of the firm. Even
when authority is delegated to individual managers (production manager, sales manager, etc.)
the final decisions have to be taken from the final ‘centre of top management’ (Board of
Directors). As the output grows, top management becomes eventually overburdened and hence
less efficient in its role as coordinator and ultimate decision-maker. Although advances in
management science have developed ‘plateaux’ of management techniques, it is still a
commonly observed fact that as firms grows beyond the appropriate optimal ‘plateaux’,
management diseconomies creep in. Another cause for decreasing returns may be found in the
exhaustible natural resources: doubling the fishing fleet may not lead to a doubling of the catch
of fish; or doubling the plant in mining or on an oil-extraction field may not lead to a doubling
of output.

B. The Law of Variable Proportions: Short-Run Analysis of Production:

If one factor is variable while the other(s) is kept constant, the product line will be a
straight line parallel to the axis of the variable factor. In general if one of the factors of
production (usually capital K) is fixed, the marginal product of the variable factor (labour) will
diminish after a certain range of production. We said that the traditional theory of production
concentrates on the ranges of output over which the marginal products of the factors are
positive but diminishing. The ranges of increasing returns (to a factor) and the range of negative
productivity are not equilibrium ranges of output.

If the production function is homogeneous with constant or decreasing returns to scale

everywhere on the production surface, the productivity of the variable factor will necessarily
be diminishing. If, however, the production function exhibits increasing returns to scale, the
diminishing returns arising from the decreasing marginal product of the variable factor (labour)
may be offset, if the returns to scale are considerable. This, however, is rare. In general the
productivity of a single-variable factor (ceteris paribus) is diminishing.

Let us examine the law of variable proportions or the law of diminishing productivity
(returns) in some detail. If the production function is homogeneous with constant returns to
scale everywhere, the returns to a single-variable factor will be diminishing. This is implied by
the negative slope and the convexity of the isoquants. With constant returns to scale everywhere
on the production surface, doubling both factors (2K, 2L) leads to a doubling of output.

In figure 3.22 point b on the isocline 0A lies on the isoquant 2X. However, if we keep
K constant (at the level K) and we double only the amount of L, we reach point c, which clearly
lies on a lower isoquant than 2X. If we wanted to double output with the initial capital K, we
would require L units of labour. Clearly L > 2L. Hence doubling L, with K constant, less than
doubles output. The variable factor L exhibits diminishing productivity (diminishing returns).

If the production function is homogeneous with decreasing returns to scale, the returns
to a single-variable factor will be, a fortiori, diminishing. Since returns to scale are decreasing,
doubling both factors will less than double output. In figure 3.23 we see that with 2L and 2K
output reaches the level d which is on a lower isoquant than 2X. If we double only labour while
keeping capital constant, output reaches the level c, which lies on a still lower isoquant.

If the production function shows increasing returns to scale, the returns to the single-
variable factor L will in general be diminishing (figure 3.24), unless the positive returns to
scale are so strong as to offset the diminishing marginal productivity of the single- variable
factor. Figure 3.25 shows the rare case of strong returns to scale which offset the diminishing
productivity of L.
RETURNS TO SCALE AND RETURNS TO FACTOR (WITH DIAGRAM)

Returns to a factor and returns to scale are two important laws of production. Both laws
explain the relation between inputs and output. Both laws have three stages of increasing,
decreasing and constant returns. Even then, there are fundamental differences between the two
laws. Returns to a factor relate to the short period production function when one factor is varied
keeping the other factor fixed in order to have more output, the marginal returns of the Variable
factor diminish. On the other hand, returns to scale relate to the long period production function
when a firm changes its scale of production by changing one or more of its factors.

Returns to factors are also called factor productivities. Productivity is the ratio of output
to the input. Factor productivity refers to the short-run relationship of input and output. The
productivity of one unit of a factor of production will be equal to the output it can generate.
The productivity of a particular factor is measured with the assumption that the other factors
are not changed or remain unchanged. Only that particular factor under study is changed.

Returns to factors refer to the output or return generated as a result of change in one or
more factors, keeping the other factors unchanged. Given a percentage of increase or decrease
in a particular factor such as labour, is it yielding proportionate increase or decrease in
production? This is analysed in 'returns to factors.'

The change in productivity can be measured in terms of

a) Total productivity The total output generated at varied levels of input of a particular
factor (while other factors remain constant), is called total physical product.

b) Average productivity The total physical product divided by the number units of that
particular factor used yields average productivity.

c) Marginal productivity The marginal physical product is the additional output

generated by adding an additional unit of the factor under study, keeping the other
factors constant.

The total physical product increases along with an increase in the inputs. However, the rate
of increase is varied, not constant. The total physical product at first increases at
an increasing rate because of the law of increasing return to scale, and later its rate of increase
declines because of the law of decreasing returns to scale.
Assumptions:
We discuss the relation between the returns to a factor (law of diminishing returns) and
returns to scale (law of returns to scale) on the assumptions that:
1. There are only two factors of production, labour and capital.

2. Labour is the variable factor and capital is the fixed factor.

3. Both factors are variable in returns to scale.

4. The production function is homogeneous.

Explanation:
Given these assumptions, we first explain the relation between constant return to scale
and returns to a variable factor in terms of Figure 14 where OS is the expansion path which
shows constant returns to scale because the difference between the two isoquants 100 and 200
on the expansion path is equal i.e.,

OM = MN. To produce 100 units, the firm uses ОС + OL quantities of capital and labour and
to double the output to 200 units, double the quantities of labour and capital are required so
that ОС2 + OL2 lead to this output level at point N. Thus there are constant returns to scale
because OM = MN. To prove that there are decreasing returns to the variable factor, labour,
we take ОС of capital as the fixed factor, represented by the CC line which is parallel to the X-
axis relating to labour. This is called the proportional line. Keeping С as constant, if the amount
of labour is doubled by LL2 we reach point Y which lies on a lower isoquant 150 than the
isoquant 200. By keeping С constant, if the output is to be doubled from 100 to 200 units, then
OL3 units of labour will be required. But OL3 > OL2. Thus by doubling the units of labour from
OL to OL2 with constant C the output less than doubles. It is 150 units at point K instead of
200 units at point P. This shows that the marginal returns of the variable factor, labour, have
diminished when there are constant returns to scale.
The relation between diminishing returns to scale and returns to a variable factor is
explained with the help of Figure 15 where OS is the expansion path which depicts diminishing
returns to scale because the segment MN > OM. It means that in order to double the output
from 100 to 200, more than double the amounts of both factors are required.

Alternatively, if both factors are doubled to ОС2 + OL2, they lead to the lower output
level isoquant 175 at point R than the isoquant 200 which shows diminishing returns to scale.
If С is kept constant and the amount of variable factor, labour, is doubled by LL2, we reach
point K which lies on a still lower level of output represented by the isoquant 140. This proves
that the marginal returns of the variable factor, labour, and have diminished when there are
diminishing returns to scale. Now we take the relation between increasing returns to scale and
returns to a variable factor.
This is explained in terms of figure 16 (A) and (B) In Panel (A), the expansion path OS
depicts increasing returns to scale because the Segment ОМ > MN. It means that in older to
double the output from 100 to 200 less than double the amounts of both factors will be required.
If С is kept constant and the amount of variable factor labour is doubled by LL2 the level of
output is reached at point K which shows diminishing marginal return as represented by the
lower isoquant 160 than the isoquant 200 when returns to scale are increasing.

In case the returns to scale are increasing strongly, that is, they are highly positive; they
will offset the diminishing marginal returns of the variable factor, labour. Such a situation leads
to increasing marginal returns. This is explained in Panel (B) of Figure 16 where on the
expansion path OS the segment OM > MN, thereby showing increasing returns to scale.

When the amount of the variable factor, labour, is doubled by LL while keeping С as
constant, we reach the output level K represented by the isoquant 250 which is at a higher level
than the isoquant 200. This shows that the marginal returns of the variable factor, labour, have
increased even when there are increasing returns to scale.

Conclusion:
It can be concluded from the above analysis that under a homogeneous production
function when a fixed factor is combined with a variable factor, the marginal returns of the
variable factor diminish when there are constant, diminishing and increasing returns to scale.
However, if there are strong increasing returns to scale, the marginal returns of the variable
factor increase instead of diminishing.
 Unit-III - PRODUCTION POSSIBILITY FRONTIERS

The Production Possibilities Frontier (PPF) is a graph that shows all the different
combinations of output of two goods that can be produced using available resources and
technology. The PPF captures the concepts of scarcity, choice, and trade-offs. The shape of the
PPF depends on whether there are increasing, decreasing, or constant costs. Points that lie on
the PPF illustrate combinations of output that are productively efficient. We cannot determine
which points are allocatively efficient without knowing preferences. The slope of the PPF
indicates the opportunity cost of producing one good versus the other good, and the opportunity
cost can be compared to the opportunity costs of another producer to determine comparative
advantage.
An opportunity cost will usually arise whenever an economic agent chooses between
alternative ways of allocating scarce resources. The opportunity cost of such a decision is the
value of the next best alternative use of scarce resources. Opportunity cost can be illustrated by
using production possibility frontiers (PPFs) which provide a simple, yet powerful too l to
illustrate the effects of making an economic choice. A PPF shows all the possible combinations
of two goods, or two options available at one point in time.

Production Possibilities

A hypothetical economy, produces only two goods – textbooks and computers. When
it uses all of its resources, it can produce five million computers and fifty-five million
textbooks. In fact, it can produce all the following combinations of computers and boo ks.

COMPUTERS TEXTBOOKS
(m) (m)
0 70
1 69
2 68
3 65
4 60
5 55
6 48
7 39
8 24
9 0
 These combinations can also be shown graphically, the result being a production
possibility frontier. The production possibility frontier (PPF) for computers and textbooks is
shown here.

Interpreting PPFs

Firstly, we can describe the opportunity cost to Mythological of producing a given

output of computers or textbooks. For example, If Mythological produces 3m computers; the
opportunity cost is 5m textbooks. This is the difference between the maximum output of
textbooks that can be produced if no computers are produced (which is 70m) and the number
of textbooks that can be produced if 3m computers are produced (which is 65m). Similarly, the
opportunity cost of producing 7m computers is 31m textbooks – which is 70 – 39.

PPFs can also illustrate the opportunity cost of a change in the quantity produced of
one good. For example, suppose Mythological currently produces 3 million computers and
65m textbooks. We can calculate the opportunity cost to Mythological if it decides to increase
production from 3 million computers to 7 million, shown on the PPF as a movement from point
A to point B. and textbooks is shown here.
 The result is a loss of output of 26 million textbooks (from 65 to 39m). Hence, the
opportunity cost to Mythological of this decision can be expressed as 26m textbooks. In fact,
this is the same as comparing the static opportunity cost of producing 3m computers (5m
textbooks) and 7m computers (31m textbooks).

Pareto Efficiency

Any point on a PPF, such as points ‘A’ and ‘B’, is said to be efficient and indicates that
an economy’s scarce resources are being fully employed. This is also called Pareto
efficiency, after Italian economist Vilfredo Pareto. Any point inside the PPF, such as point ‘X’
is said to be inefficient because output could be greater from the economy’s existing resources.
Any point outside the PPF, such as point ‘Z’, is impossible with the economy’s current s carce
resources, but it may be an objective for the future. Pareto efficiency can be looked at in another
way – when the only way to make someone better off is to make someone else worse off. In
other words, Pareto efficiency means an economy is operating at its full potential, and no more
output can be produced from its existing resources.
 Pareto efficiency is unlikely to be achieved in the real world because of
various rigidities and imperfections. For example, it is unlikely that all resources can be fully
employed at any given point in time because some workers may be in the process of training,
or in the process of searching for a new job. While searching for work, or being trained, they
are unproductive. Similarly, an entrepreneur may have wound-up one business venture, and be
in the process of setting-up a new one, but during this period, they are unproductive. Despite
this, Pareto efficiency is still an extremely useful concept.

It is a useful concept for two reasons:

1. It can be an objective for an economy because it can set a direction towards which an
economy can move.
2. It can help highlight the imperfections and rigidities that exist in an economy and
prevent Pareto efficiency being achieved.

Productive and Allocative Efficiency

A point on a PPF is, by definition, productively efficient in that all of the economies
resources are being fully employed, and their is no waste or unemployment. However, from
the consumer’s (or society’s) point of view a particular combination of goods m ay not be
allocatively efficient. For it to be allocatively efficient it must satisfy consumer demand and
consumer preferences. As will be seen later, allocative efficiency is more formally expressed
as a level of output where the marginal benefit to the consumer or the last unit consumed equals
the marginal cost of supply of that unit. Clearly, not all combinations will satisfy this condition.
 In the example shown, a society may produce only meat or vegetables, but its
population prefers a varied diet. Hence, point A is likely to be much more allocatively efficient
than point B and C, because these do not meet society’s preferences.

Increasing Opportunity Cost

Opportunity cost can be thought of in terms of how decisions to increase the production
of an extra, marginal, unit of one good leads to a decrease in the production of another good.
According to economic theory, successive increases in the production of one good will lead to
an increasing sacrifice in terms of a reduction in the other good. For example, as an economy
tries to increase the production of good X , such as cameras, it must sacrifice more of the other
good, Y, such as mobile phones.

This explains why the PPF is concave to the origin, meaning its is bowed outwards. For
example, if an economy initially produces at A, with 8m phones and 10m cameras (to 20m),
and then increases output of cameras by 10m, it must sacrifice 1m phones, and it moves to
point B. If it now wishes to increase output of cameras by a further 10m (to 30m) it must
sacrifice 2m phones, rather than 1m, and it moves to point C; hence, opportunity cost increases
the more a good is produced. The gradient of the PPF gets steeper as more cameras are
produced, indicating a greater sacrifice in terms of mobile phones foregone.
Marginal Analysis

Economic decisions are taken in a marginal way, which means that decisions to
produce, or consume, are made one at a time. For example, a typical consumer does not decide
to drink four cans of cola at the beginning of each day, rather they make four individual
decisions, one at a time. Similarly, a baker does not decide to produce 5,000 loaves of bread in
a year, but decides each day or week what to produce. Economic decisions are marginal
because conditions are constantly changing, and consumers and producers would be highly
irrational if they did not consider this. Hence, each production or consumption decision is
assumed to be made one at a time so that changing conditions can be assessed.
 Unit-III OPTIMUM PRODUCT MIX OF MULTI PRODUCT FIRM

In economic literature, we consider profit maximization is the main goal of any business
firm or a rational producer. When we talk about the profit maximization objective, we are
implicitly referring to the economic efficiency rather than technical efficiency. Technical
efficiency does not consider the financial aspect of production; it only considers technical or
engineering aspects of production like we did in study of production function and isoquant.

What is a Product Mix?

A company’s product mix is the range of products it offers. Companies are often
reluctant to limit production of a particular product, especially if it is selling well. In most
cases, the more you make, the more potential there is for profit generation. A product mix is
just what it sounds like — it’s the mix of products you sell. Your mix can be a combination
of different products, like tennis shoes and tennis socks, or it can be a mix of the same
product, but in different sizes or colors. In the first scenario, you might have cost of
production and profit margin considerations that determine your optimal product mix. In the
latter scenario, demand for a particular size or colors might guide your product mix decision.
However, in some cases it is wise to limit production. Let’s take trainers as an example. Some
companies will only make a certain number of trainers to prevent a loss in value. Limiting
production protects exclusivity, helping to maintain or increase value.

What is Your Optimal Product Mix?

The optimal product mix for one small business is not the same mix for another
business, even when they make the same items. A variety of factors beyond profits per unit
guide your decision making. These might include gross profits vs. profit margin, demand for
particular products, time to make products, how shipping and delivery affects profits and
customer satisfaction and returns. Therefore, your optimal product mix might not be the one
that gives you the most profit on paper, because on paper, you will sell every product you
produce with no errors or returns.
Gross Profits vs. Profit Margins

Let’s say you sell a frozen pizza with everything for $3 per pizza. You sell a cheese
pizza for $2. You make a $1.25 profit selling pizzas with everything, and only $1 per pie
selling cheese pizzas. You might want to sell more of the cheese pizzas. That’s because the
cheese pizza only costs you $1 to make, giving you a 50 percent profit margin, while the
pizza with everything costs you $1.75 to make, giving you a 42 percent profit margin. If you
invest $100 into making and selling cheese pizzas, your total gross profits will be $100. If
you invest $100 into making and selling pizzas with everything, your total gross profits will
be $71.25.

Quantity vs. Quality

The difference between optimal and maximal is that the first refers to “best” while
the second refers to “most.” Your maximal product mix might be selling only men’s tennis
shoes, instead of a mix of men’s and women’s shoes. However, if you have higher customer
returns of men’s tennis shoes than women’s shoes, that’s not the optimal product mix. Even
if you get to keep your customer’s money with a no-return policy, you might lose future sales
from these customers and generate bad reviews online, decreasing your sales. If you offer
returns and exchanges, your cost of producing and selling the men’s shoes has now increased.

Factoring in Demand

A key factor to consider when determining your optimal product mix is the demand
for your products. Let’s say you can make 1,000 tennis shoes per month, but only 900 men’s
shoes, which bring higher profit margins than your women’s shoes. You then make 900
men’s shoes and 100 women’s shoes and max out your production capabilities. Better yet,
you sell all 1,000 men’s shoes and women’s shoes. The problem is, the demand for women’s
tennis shoes is high enough that you keep running out of women’s shoes. Your female
customers come to your website and can’t find what they want, so they start shopping
elsewhere. Pretty soon, you’ll lose this part of your customer base and won’t be able to sell
1,000 shoes per month. In order not to lose those 100 sales per month, which might contribute
significantly to your bottom line, you decide to only make 800 men’s shoes each month so
that you can satisfy the demand for your women’s shoes, ensuring that you are able to sell
1,000 shoes per month.

Optimum Product Mix of Multi Product

In real world, business firm produces more than one product. In this post, we will
discuss about the profit maximizing conditions of a multi-product firm. Also note that
equilibrium of a firm equally means profit maximization of that firm and vice versa. Before we
delve into the core topic, let us first go through the very important tools from economic
profession – Edgeworth Box diagram, production possibility curve and iso-revenue line. These
tools are the fundamentals to understand the equilibrium of multi-product firm. Then after, we
will elaborate the necessary and sufficient conditions for equilibrium of a multi-product firm.
▪ Assumptions
▪ Edgeworth Box diagram and contract curve
▪ What does production possibility curve show?
▪ What is iso-revenue line?
▪ How a multi-product firm reaches equilibrium?

Assumptions

The exposition of theory rests upon the following assumptions:

▪ Objective of a firm is profit maximization.

▪ Firm is multi-product firm and produces at least two product X & Y.
▪ Each production function uses capital and labor to produce one single good i.e.
production functions to individual good take the form of X =f (K,L) and Y =f(K,L).
▪ Prices of factors inputs and prices of products remain constant at least during the
analysis.
▪ Technology of production remains same throughout the analysis.

Based on the above assumptions, we can say that firm produces only two goods – X and
Y – using both of the factor inputs capital, K, and labor, L. Also note that there are two types
of production techniques – X =f (K,L) and Y =f(K,L) to produce goods X and Y respectively.
Each production technique can be represented by the corresponding sets of isoquants. To say,
we can assume set of isoquants X’s to represent technique to produce X good, and set of
isoquants Y’s to represent technique to produce Y good. At this backdrop, let us present the
Edgeworth Box diagram in the following section.
What does Edgeworth Box diagram show?

It is very important tool in economics and shows how economic efficiency one can
obtain with the best usages of limited productive resources. Not every combination of resources
– capital and labor- is efficient within the Edgeworth Box, but some points that form contract
curve are efficient. Edgeworth Box diagram depicts how to mobilize resources from inefficient
usages to efficient usages.

Also observe the following facts in Edgeworth Box:

$latex \Right arrow$ Set of isoquants X’s originating to Ox denotes production function
X=f(K,L) and set of isoquants Y’s originating to Oy denotes production function Y=f(K,L).
$latex \Right arrow$ The higher the isoquants X’s, the larger the output of X it shows.
Similarly, the further down the isoquants Y’s, the larger the output of Y it shows.

$latex \Right arrow$ Total amount of capital K – shown in vertical axis, and total amount of
labor L – shown in horizontal axis, are the total available resources.

Explanation of Edgeworth Box diagram

We can perceive isoquants X’s and Y’s, facing to each others, will be tangent at points
somewhere within the Edgeworth Box. We can expect very large number of isoquants X’s and
Y’s despite we have shown few of them, and thus, large number of such tangency points. If we
connect such points of tangency, we get what is called a contract curve (curve OxOy in picture).
This curve is the locus of points representing all the economically efficient methods of
producing X and Y goods. Any point off this curve implies the inefficient use of limited
resources.

For instance, suppose firm produces at point T (in above figure), where it uses OxK1
of total capital K and OxL1 of total labor L to produce X3 output. Similarly, it uses remaining
resources – K1K of total capital K and L1L of total labor L – to produce Y3 output. However,
moving towards points P and Q on contract curve while using the same amount of resources,
firm can produce more of at least one good without reducing the output of other good. At point
P, firm can produce Y4 without reducing X3. Similarly, at point Q, firm can produce X4
without losing Y3. If the firm moves to points in between P and Q, say point m, then it can
produce more of both goods using the same resources. Thus, only points on contract curve
represent the efficient method of production; any points off this curve indicate inefficient
method of production.

What is production possibility curve?

It is the very important tool in economics which enables producers or firms to

efficiently choose from the alternative products. We can derive production possibility curve
(PPC) directly from contract curve of Edgeworth Box by projecting it (contract curve) into X,Y
plane of goods.
 Points P, m and Q on contract curve are the respective points P’, m’ and Q’ on PPC
curve. Also note the corresponding amount of goods X’s and Y’s in PPC curve. Any points
above the PPC curve YP’m’Q’X are desirable but unattainable given the state of technology
and factor inputs. Likewise, any points below the PPC curve are attainable but undesirable
because they represent the inefficient usages of resources.

The PPC curve is also called product transformation curve because moving from one
point to other on PPC implies the transformation of one product to another. However, the
transformation of product takes place via the diversion of resources from one product to
another.

What is marginal rate of product transformation?

It is the rate at which one product is transferred to another product, holding constant the
resources. In other words, it is the amount of Y good forgone for the additional one unit of X
good, and is denoted by MRPTx,y. The more we transfer Y to X, the lesser the X we get from
transformation; and thus, MRPTx,y increases. The concave shape of PPC curve is the result of
increasing marginal rate of product transformation. Also note that marginal rate of product
transformation (also a slope of PPC at that point) at any point on PPC curve is given by the
slope of tangent at that point.

What is iso-revenue line?

It is a locus of combinations of products that gives the same revenue. In other words, it
represents the various combinations of X and Y goods whose sales give the same amount of
revenue to firm. That means to say, any points on iso-revenue curve give the constant level of
revenue to firm. The higher the iso-revenue lines from the origin, the greater the revenue it
depicts.

Let us present iso-revenue line mathematically,

R = Px . X + Py . Y
where Px is price of good X, Py is price of good Y, and R is revenue. Also note that the slope
of iso-revenue line is given by the ratio of Px to Py i.e. Px / Py.
How a multi-product firm reaches equilibrium?

After having introduced with PPC and iso-revenue line, it is time to explore how a
multi-product firm reaches equilibrium (maximizes revenue for the given prices of products).
Firm has to maximize revenue constrained by given prices of factor inputs and products, given
PPC, and given limited factor inputs. So, this analysis is a constrained profit maximization.

There are two conditions for the profit maximization:

1. Slope of PPC must equal to slope of iso-revenue line i.e. MTPTX,Y = PX /PY .
2. PPC must be concave to origin.
In the following figure, firm reaches equilibrium at point E fulfilling the both conditions,
and produces X* amount of X good and Y* amount of Y good. Given the prices of products X
and Y goods, and thus given PX /PY, iso-revenue line MN is the highest possible line to
represent highest amount of revenue. Any lines above MN line are desirable but unattainable.
Similarly, any lines below MN line are attainable but undesirable and inefficient because, they
do not maximize profit. Thus, only MN line maximizes profit fulfilling the required conditions.

What happen if PPC becomes convex to origin? The answer is, it ends with the corner
solutions producing one of either goods, and resulting in still larger amount of revenue than
otherwise. In such a situation, thus, we have to rule out the assumption of multi-product firm.
This is on contradiction to our basic premise, so we consider only concave PPC.