MBA 534 - Managerial Economics 1

Problems in estimating production function empirically for a ceramic tile manufacture in Sri Lanka (An Assignment)

By

J.B.A.Ravinath Niroshana (2009/MBA/WE/71) Semester -Second half 01st of May 2010

Course Lecturer

: :

MBA 534 - Managerial Economics Dr. Navaratnam Ravinthirakumaran

Postgraduate and Mid-Career Development Unit Faculty of Management and Finance University of Colombo

MBA 534 - Managerial Economics 2 Table of Contents Abstract Problems in estimating production function empirically for a ceramic tile manufacture in Sri Lanka Introduction Ceramic Tile Market Market Segmentation Product Forecasts Ceramic Floor Tiles Ceramic Wall Tiles Production function Production decisions A two-input Cobb-Douglas production function Problems in estimating production function empirically Conclusion Reference Bibliography 4 4 5 5 5 5 5 5 7 8 7 12 13 14 3

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Abstract Ceramic Tiles manufactured in Sri Lanka are recognized as a Class 1 tile product in the world due to the quality of raw materials (clay) used to production. Ceramic tile will continue to benefit from its perception as a durable, long-lasting flooring choice. Additionally, ceramic tile has an environmentally friendly profile because it can be recycled, has low toxicity and is made from clay, which is in abundant Supply. Although above facts are as such, the ceramic industry faced some problems especially in the production process, both in the Short-Run as well as in the Long-Run. For example Capital is a necessary but not a sufficient condition for the economic growth of an underdeveloped country [like Sri Lnaka] (Lipsey, 1968).This is fully applicable to the tile industry as well. However in contrast with capital, labour or rather cheap labour available freely .Although cheap labour is available in Sri Lanka, what lack is the a required skill or Skills labour. Therefore this analysis is done in the light of production function, Cobb-Douglas production function, Theory of Production and Theory of Cost for identify the problems in estimating production function empirically for Sri Lankan Ceramic Tile Manufacture XYZ Company.

Keywords: Theory of Production, Theory of Cost, production function, Cobb-Douglas production function, Ceramic Tile Industry, Capital, Labour

MBA 534 - Managerial Economics 4 Problems in estimating production function empirically for a ceramic tile manufacture in Sri Lanka Introduction The XYZ Company is a Ceramic Tile manufacture in Sri Lanka. The main factory for production is located in Dankotuwa. The main raw material for production is Clay and therefore the factory for production has been located in Dankotuwa area, which is famous for first class Clay. Apart from that labour cost in this area is very low. Ceramic tiles which can be classified by their application include floor and wall tiles. This report encompasses production of ceramic tiles that are used for flooring and wall coverings surfaces in residential and non-residential building applications. Ceramic floor tiles are available in three primary types: glazed, unglazed and mosaic. As we know Sri Lanka is a developing country, which is located in South-Asia region. Capital is a necessary but not a sufficient condition for the economic growth of an underdeveloped country (Lipsey, 1968). Since Sri Lanka is a developing country, lack of capital is the major problem, although it is the very important factor for production. However in contrast to capital, labour is an economical factor in country like Sri Lanka. Ceramic Tile Market Market for ceramic tiles are perfectly competitive, and, hence entry and exist to the market has not been restricted. Ceramic floor and wall tile demand is driven primarily by demand for hard surface flooring and wall coverings. Hard surface flooring and wall covering demand patterns are, in turn, closely related to the highly cyclical building construction sector both residential and nonresidential. The outlook in the residential market strongly impacts demand for flooring, and wall tiles, while the nonresidential markets influence is mainly directed toward ceramic flooring tiles. Overall demand for ceramic tiles is less sensitive to economic cycling than is demand in many other construction-related industries because of the wide utilization of ceramic tile in repair and improvement, rather than in new construction projects. Additionally, ceramic tiles are often installed for purely decorative purposes that are completely independent of either repair projects or new construction activity.

MBA 534 - Managerial Economics 5 Market Segmentation Markets for ceramic tiles can be broadly classified in to two categories: Residential; and Non-residential building markets.

Product Forecasts Ceramic Floor Tiles Growth in ceramic floor tile demand will be spurred by technological innovations such as enhanced visuals, new sizes and shapes, unique finishes and colors, and enhanced dimensional profiles. Other innovations such as installation and grout improvements will also support gains. Ceramic tile will continue to benefit from its perception as a durable, long-lasting flooring choice. Additionally, ceramic tile has an environmentally friendly profile because it can be recycled, has low toxicity and is made from clay, which is in abundant supply. Consumer preferences toward high-end and custom flooring will aid value demand growth. Increasing affordability and availability of floor warming systems will also support demand for ceramic tile.

Ceramic Wall Tiles Ceramic tile will remain the most stable segment of the overall wall covering industry, because demand is based more broadly across the entire construction market, and because ceramic wall tile has not suffered from competition from alternative materials. Specialty ceramic wall tiles will be supported by growing use in niche applications in which their highly decorative aesthetics are prized. However, the overall size of this market will remain limited by the elevated labor typically required to install and maintain these specialty tile.

MBA 534 - Managerial Economics 6 Production function Production refers to the economic process of converting of inputs into outputs (Lipsey, 1968).In order to produce the goods or services that it sells, each firm exists in the society needs inputs. Among the many inputs entering into Tile production are clay, chemicals, paints, electricity, LP Gas, the work space of the factory, machinist, designers, accountants, spray-painting machines, forklifts, painters, and managers. These can be grouped into four broad classes: (1) inputs to the Tile firm that are outputs from some other firm, such as electricity, paints, chemicals, and LP Gas; (2) inputs provided directly by the nature, such as land and air; (3) efforts of people, such as the services of workers and managers; and (4) the use of plant and machines. The gifts of nature, such as soil and raw materials, called land (item 2 above); physical and mental efforts provided by people, called labour (item 3 above); and the services of factories, machines, and other man-made aids to production, called capital (item 4 above).These are traditionally called factors of production, though we also refer to them more simply as inputs (Lipsey and Chrystal, 2009). As described by Hirschey (2009), a production function specifies the maximum output that can be produced for a given amount of input. Whereas, Lipsey and Chrystal (2009), described the production function relates inputs to outputs. It described the technological relation between the inputs that a firm is uses and the output that it produces .By considering above definitions production function can be mathematically represent as follows: Q=f(X1, X2 , X3XK) Where: Q is the output (either good or Service);and
X1, X2 , X3XK are the quantities of k different inputs used in its production, everything

being expressed as rates per period of time. This was first proposed by Philip Wicksteed (1894).Production uses resources to create a good or service that is suitable for exchange. This can include manufacturing, storing, shipping, and packaging.

MBA 534 - Managerial Economics 7 Production decisions The production technology for the one-output/two-inputs case is (imperfectly) depicted in below Figure. Output (Y) is measured on the vertical axis. The two inputs, which we call L and K which are called labor and capital respectively, are depicted on the horizontal axes. All capital is assumed to be endowed, i.e. there are no produced means of production. The hill-shaped structure depicted in Figure is the production set. Notice that it includes all the area on the surface and in the interior of the hill. The production set is essentially the set of technically feasible combinations of output Y and inputs, K and L.(Samuelson, 1972)

Source: Paul A. Samuelson, Collected Scientific Papers, 1972: p.174 Further Samuelsson (1972) is described; production decision is a feasible choice of inputs and output - is a particular point on or in this "hill". It will be "on" the hill if it is technically efficient and "in" the hill if it is technically inefficient. Properly speaking, the production function Y= f (K, L) is only the surface (and not the interior) of the hill, and thus denotes the set of technologically efficient points of the production set (i.e. for a given configuration of inputs, K, L, output Y is the maximum feasible output). Obviously, the hill-shape of the production function indicates that the more we use of the factors, the greater output is going to be (at least up to the some maximum, the "top" of the hill). The round contours along the production hill can be thought of as topographic contours as seen on maps and will serve as isoquants (Samuelson, 1972). Hirschey (2009) described the term isoquant derived from iso, meaning equal, and quant, from quantity denotes a curve that represent the different combinations of inputs that can be efficiently used to produce a given level of output. Efficiency in this case refers to technical efficiency, meaning the least-cost production of a target level of output.

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Indicate imperfectly substitutability among inputs

Indicate perfectly substitutability

Indicate perfectly complements

Figure(s) Representative Isoquants graphs for output Q1, Q2 and Q3 for input X and Y. A two-input Cobb-Douglas production function In economics, the Cobb-Douglas functional form of production functions is widely used to represent the relationship of an output to inputs. As described by Cobb and Douglas (1928): for production, the function is Q=AKL Where:

Q = total production (the monetary value of all goods produced in a year) L = labor input K = capital input A = total factor productivity and are the output elasticities of labor and capital, respectively. These values are constants determined by available technology.

Output elasticity measures the responsiveness of output to a change in levels of either labor or capital used in production, ceteris paribus. (Cobb and Douglas,1928)

Problems in estimating production function empirically However, finding capital requirements such as burners and other plants, buildings for factory seems to be the major problem faced by the industry. However in Sri Lanka labour cost is relatively low compare to developed countries. As described by Lipsey and Chrystal (2009), Production can be basically divided in to three parts as Short-Run, Long-Run and Very Long Run. In short run firm may very some inputs while keeping other inputs as being unchanged.

MBA 534 - Managerial Economics 9 Whereas in long run and very long run all the inputs are being changed. First let us look production function which has described above with two variables Labour (L) and Capital (K). Q=f (L, K) In Short Run only labour will change (I.e. Capital will not change). As described by Hirschey (2009), Total Product (TP) is equal to total quantity of output and Average Product (AP) is equal to total product divide by total input. Marginal Product (MP) is change in quantity when one additional unit of input used. He further explained that if MP is greater than AP, then AP is rising. If MP is less than AP then AP is falling. When MP is equal to AP, then AP is maximum. Where; 1-Marginal Product (MP) 2- Average Product (AP) 3- Total Product (TP)

The point where MP graph intersect with X- axis is a very important point. At that point rational producer should stop the production process. Therefore as a production manger of the company it is necessary to identify this point. This is referred as law of diminishing returns. After this point fixed input capacity is reached; additional X causes output to fall. Hirschey (2009), described following three stages in Law of diminishing returns as depicted in below figure.

Source: Mark Hirschey (2009), Managerial Economics: An integrative Approach, 2009: p.215

MBA 534 - Managerial Economics 10 In stage 1 specialization and teamwork cause AP to increase when additional input is used. In stage 2 specializations and teamwork continue to result in greater output when additional X is used. In stage 3 fixed input capacity is reached; additional X causes output to fall (Hirschey, 2009).In Cobb-Douglass production function described above if + = 1, is said as constant returns to scale, that is output change is equal to the input change. If + >1, is said asincreasing returns to scale, that is output change is greater than the input change. That is unit cost gradually deceasing firm enjoy the economies of Scale. If + < 1, is said as decreasing returns to scale, that is output change is lesser than the input change.Therfore unit cost is gradually increased and firm enjoys diseconomies of scale(Hirschey, 2009). Therefore in Short-Run, the company can effectively use Labour to get the desired output or to keep economies of scale. However as described earlier elevated labor typically required to install and maintain these specialty tiles. The required skills cannot be achieved during the short run and it will affect the performance of the company. In short run it is difficult to enhance capital. However possible sources of capital are Banks, Finance Companies,etc. In Long Run both variables in the production function are being changed. Therefore for enhance capital for improve the efficiency it is necessary to choose proper bank with low interest rate. As described by Hirschey (2009) to get the optimal combination of labour and capital, we can use isoquant graphs. For underdeveloped country like Sri Lanka we can choose higher labour and lower capital combination for achieve the desired output level or economies of scale. The below figure depicts a typical Long Run average cost curve(LRAC).

Source: Mark Hirschey (2009), Managerial Economics: An integrative Approach, 2009

MBA 534 - Managerial Economics 11 As described by Lipsey (1968) when LRAC is declining we say the firm is experiencing economies of scale. To keep economies of scale reduce the cost of production and keep good relationship with workers are essential. However due to recent union actions it is difficult to maintain this standard. In this point it is necessary to have some kind of strategy to deal with. However in spite of above described problems if we can maintain smooth production flow then the production cost will reduce and the company will perform well. Further in the long run due to learning and experience, efficiency and effectiveness, of the workers increased and it help to reduce the production cost. Below graph graphically is represented such kind of situation. Therefore Knowledge based economy is always produces less cost and hence economies of scale can be achieved. Therefore constant training and development very vital for organization in a Long Run. It will also lead innovation and hence overall cost reduced and required productivity can be achieved.

Source: http://tutor2u.net/economics/content/topics/competition/competition.htm As described by Lipsey and Chrystal (2009), the equilibrium price is determined in the by the industry demand and supply curves. Individual firms accept this price to sell their goods at because they are price takers and they supply the level of output that maximizes their output. In the diagram above, the firm is making abnormal profits as the Average Revenue(AR) is greater than the Average Cost(AC) at the profit maximising level of output Marginal Revenue (MR)=Marginal Cost(MC). Tile production need large amount of skilled labour especially cater the needs of perfectly competitive market hence fully optimize production process can be achieved.

MBA 534 - Managerial Economics 12 Conclusion As described above rational producer always try to increase the total revenue by minimizing the production cost. For that the tile company should has a fully optimized production process and this is a mandatory requirement to achieve the desired economic goal of the company, which is maximize the profit. However capital is a necessary in long run, but not a sufficient condition for the economic growth of an underdeveloped country. Further it is difficult to find skilled labour specially art work, painting, and similar operations of the production process. Further government tax for LP Gas which is input to the production is a major factor when we consider about Global market. Therefore to survive in the competitive market the production manger should keep healthy relationship with workers are necessary. Reducing costs such as marketing cost will reduce the production cost. However marketing is required to some extent as far as the competitive market is concerned. Therefore the production manager should take appropriate decisions for following major queries to achieve the companies economic Goals: How much output to produce; whether to produce or to shutdown; what input combination to use; and what type of technology to use.

MBA 534 - Managerial Economics 13 Reference Hirschey, M (2009), Managerial Economics: An integrative Approach, Cengage Learning, India. Lipsey, R.G. (1968), An Introduction to Positive Economics,LPE India edition Lipsey, R.G. & Cheristal,K.A. (2009) Economics, Oxford university press, Oxford. Cobb, C. W. and P. H. Douglas. 1928. A theory of production, American Economic Review 18(1):139 Paul A. Samuelson, Collected Scientific Papers, 1972: p.174

MBA 534 - Managerial Economics 14 Bibliography Hirschey, M (2009), Managerial Economics: An integrative Approach, Cengage Learning, India. Lipsey, R.G. (1968), An Introduction to Positive Economics,LPE India edition Lipsey, R.G. & Cheristal,K.A. (2009) Economics, Oxford university press, Oxford. Cobb, C. W. and P. H. Douglas. 1928. A theory of production, American Economic Review 18(1):139 Paul A. Samuelson, Collected Scientific Papers, 1972: p.174 Nanayakkara, G. (2008). A Handbook for Academic and Professional Writing in Management

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