Production (ISO Quant)

Production and Cost Analysis

Production process involves the transformation of inputs in to output.

Basic Questions
1. 2. 3. 4. Whether to produce or not. How much output to produce. What input combination to use. What type of Technology to use.
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Production Function
A production function is the functional relationship between inputs and output Maximum output. That can be obtained for a given combination of inputs. It expresses the technological relationship between inputs and output of a product Q = f (L, K)
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Economic Efficiency vs Technical Efficiency

A firm is Technically efficient when it obtains maximum level of output from given inputs. A producer cannot reduce one input and at the same time maintain the output at same level .
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A firm is economically efficient when it produces a given amount of output at the lowest possible costs for a combination of inputs provided that prices of inputs are given/ constant. How to produce a given amount of output at lowest cost.
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Short Run & Long Run

All inputs can be divided in to Fixed inputs Plant, Buildings, Equipment. Variable Inputs Amount can be changed during the short run. Short Run is defined to be that period when some of the firms inputs are fixed.
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Long Run is that period over which all the firms inputs are variable and the firm has the flexibility to adjust or change its environment.
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Production Function
Short Run PF Returns to a factor One variable factor Short run analysis Long Run PF Returns to Scale All factors variable Long run analysis

Law of variable Proportions

Law of returns to Scale

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Stage of Production
Stage I MP>O, AP rising thus MP>AP

Stage II MP>O, AP falling. MP<AP but TP rising (because MP>O)

Stage III MP<O. In this case TP is falling

Question : Why a profit maximizing producer would produce in stage II and not in stage I or III. Explain.

Causes of the operation of Law of variable proportion

Indivisibility of factors (a critical minimum factor to be employed, fuller use of fixed factor) Division of labour or specialization Imperfect substitution Leads to diminishing returns. 10

Significance of law of variable proportion

Firm to use its resources rationally (Capacity Building)/ Capacity Planning Firm to understand the trade off between marginal benefit and costs
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Law of returns to a factor & returns to scale

Law of returns to a factor is a short run phenomenon, whereas the law of returns to scale operation in the long run. Returns to scale refers to the change in output as all factors change in the same proportion.
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I. Q = f (l, k) II. Q1 = f (al, ak)

Stages of Returns to Scale

I. Increasing Returns to Scale II. Constant Returns to Scale III. Diminishing Returns to Scale
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Theory of Production : IS Quant Curve Approach

ISO = Equal Quant = Quantity of Product An ISO-Quant curve approach is a curve which represents different combinations of two factors which field same level of output.
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Other Names of ISOQuant

Equal product curve Product Indifference curve Constant Product curve
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Assumption of the concept of ISO-Quants

There are only two factors of production There exists substitutability of the factor i.e K (Capital) and Labour Technique of production is constant Factors can be substituted
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Returns to scale & ISOQuant Approach Constant Returns to Scale

Doubling the input doubles the output

Input and output are increasing proportionately

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Diminishing Returns to Scale

Change in factor inputs results in to proportionately smaller changes in outputs.
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Increasing Returns to Scale

Doubling of Resources more than doubles the level of output.
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 Factors of production can be divided in to smaller units. An ISO Quant Map is a set or family of ISO- Quants. The concept of ISO-Quant is based on Marginal rate of technical substitution (MRTS) MRTS = Rate at which one input can be substituted for another input without changing the level of output. MRTS = K L 20

To be in equilibrium the entrepreneur equates the MRTS or the ratio of Marginal Physical product of two factors with the Price Ratio of the two factors.
Expansion Path An expansion path is the line which reflect best input combinations, least cost method of producing different levels of output assuming that input prices are constant.
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Optimum Combination of Inputs

MRTS = PL PK or Marginal productivity of Labour = PL Marginal productivity of K PK or MP of Labour = MP of K Price of Labour Price of K
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ISO- Cost Line

It is a locus of all combinations of two inputs which the producer can buy using his fixed outlay at fixed input price. Other Names: Factor Price Line Outlay line Firms Budget Control Line
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Producer Equilibrium

MRTS = PL LK PK

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