PRODUCTION ANALYSIS

TOTAL, AVERAGE & MARGINAL PRODUCTS

- For a two – input production process, TPL is defined as the maximum rate
of output forthcoming from combining varying rates of labour input with a
fixed capital input.
__
TPL = f (K , L)
__
Similarly TPK = f (K , L)

- AP is total product per unit of the variable input & is found by dividing the
rate of output by the rate of the variable input

APL = TPL
-----
L

APK= TPK
-----
K

- MP is defined as the change in output per one – unit change in the variable
input . i.e.

∆Q ∆Q
MPL = ---- & MPk = ------
∆L ∆K

Labour Input TPL APL MPL

0 0 - -
1 20 20 20
2 50 25 30
3 90 30 40
4 120 30 30
5 140 28 20
6 150 25 10
7 155 22 5
8 150 19 -5
  PRODUCTION IN THE SHORT RUN

- The short run is that period of time over which the input of only one
factor can be increased; the other factors of production can’t be varied.
E.g. a mfging firm wishing to increase its output may be unable to have
a bigger factory built overnight and so in the short run can produce
more only by employing more labour.

- Those factors which can be varied in the short run ( labour ) are called
the variable factors; those which can’t be varied are called the fixed
factors (Capital)

- In the short – run we have a law of production relating to the change of

only one factor of production i.e. labour while the other factor namely
capital is kept constant. This law is called the LAW OF (eventually)
DIMINISHING RETURNS TO FACTOR.

e.g. Consider a clothing manufacturer having a 5,000-square – feet building

housing 100 sewing machines. Obviously, having only one or two
workers in such a plant would be inefficient.

- As more labour is added, production should increase rapidly as more

machines are placed in operation and better coordination achieved
among workers & machines.

- However, as even more labour is added, the efficiency gains will slow
and output will increase but at a slower rate (i.e. MP will decline).

- Finally, a point may be reached where adding more labor actually will
cause a reduction in total output i.e. MP becomes – ve.

- This example illustrates an important economic principle known as the

law of diminishing marginal returns. This law states that when
increasing amounts of the variable input are combined with a fixed level
of another input, a point will be reached where the MP of the variable
input will decline. This law is based on actual observation of many
production processes.

 Optimal employment of a factor of production

 - ABC Co. has a physical capital stock valued at about $ 36 billion.
Consider this to be the fixed input for the firm. About 7,60,000 workers
are employed to use this capital stock. What principle guide the
decision about the level of employment ?

- In general, to maximize profit, the firm should hire labor as long as the
additional revenue associated with hiring another unit of labour
exceeds the cost of employing that unit.

- Suppose that the MP of an additional worker is (4) units of o/t & each
unit of o/t is worth ($ 10,000). Thus the additional revenue to the firm
will be ( $ 40,000) if the worker is hired.

- If the additional cost of a worker ( i.e. the wage rate ) is $ 30,000, that
worker will be hired. If it’s $ 45,000, the worker should not be hired
becoz profit would be reduced by $ 5,000. MRPL = w

 Relationship between average & marginal:

When marginal is less than average, average falls.

When marginal is greater than average, average rises.

Q. Kids & Bags company manufactures school bags. Currently it is selling

1000 bags at a price of Rs.500 per bag. Total cost is Rs.4,50,000 of which Rs.
1,50,000 is fixed cost and Average variable cost (AVC) is constant.
Kids and Bags co. aims to maximize profits. The marketing manager of the
company believes that if the company could reduce the price to Rs. 400 per
unit, its sales would increase by 60 %.

If you were the CEO of the Company, would you approve of the reduction in
price. Come out with reasons.

Q. AC = 500/Q + 10 + 5Q.

What is the fixed cost of the company.

- A firm may face any of the five situations in the short run :

(i) AR > AC (Abnormal profits )

(ii) AR = AC (No profit no loss )
(iii) AR > AVC <ATC (Partial losses )
(iv) AR = AVC (Maximum permissible losses )
(v) AR < AVC (Shutdown situation where production Is stopped)

 BREAK – EVEN OUTPUT:

- This is basically an accounting concept. The break – even chart of the

accountant illustrates at what level of output in the short-run, the total
revenue just covers the total costs.

TR = P.Q

TC = Total Fixed cost + Total Variable cost

= F + AVC x Q

At Break even point :

T R = TC

i.e. P.Q = F + AVC x Q

PQ – AVC x Q = F ; Q ( P – AVC ) = F

Q = F = Total fixed costs________

P – AVC Price – Average Variable Cost

ILLUSTRATION

T R = 60 Q
 TC = 1800 + 40 Q

Break – even o/t volume = 1800 = 90

60–40

& Break - even o/t value = 90 x 60 =5400/-

- ( P-V) is called ‘ CONTRIBUTION MARGIN per unit of output.

Q. Micro Applications inc. is a small firm that specializes in the production & mail –
order distribution of computer programs for Micro Computers. The accounting
deptt. has gathered the following data on development and production costs for a
typical programme & the documentation ( i.e. the manual ) that must accompany
the programme.

DEVELOPMENT COSTS ( FIXED ):

 Programme development $ 10,000

Manual preparation & typesetting $ 3,000

Advertising $ 10,000

Total $ 23,000

Variable costs per unit :

Blank disk $ 2.00

Loading cost $ 0.50

Postage & handling $ 1.25

Printing of manual $ 2.75

Total $ 6.50

A typical programme of this type, including the manual, sells for $ 40 per unit.

a) Determine the breakeven no. of programme & the total revenue associated
with this volume,

b) Micro applications has a minimum profit target of $ 40,000 on each new

programme it develops. Determine the unit & dollar volume of sales
required to meet it.

c) While this programme is still in the development stage, market prices for
software fall by 25 percent due to a significant increase in the no. of
Programmes being supplied to the market. Determine the new breakeven
unit & dollar volumes

Ans. 1. Based on fixed costs of $ 23,000, a price of $ 40 per unit, and

variable costs per unit of $ 6.50, the unit volume required to break
even is
Qe = Fixed cost = 23000 = 686.6
---------------- -------------
P – AVC 40 – 6.50

Total revenue at this o/t rate if determined by multiplying price times

the breakeven quantity.
 TR = PQ e = 40 ( 686.6) = $ 27, 464.

2. The Qy necessary to meet the profit target of $ 40,000 is

FC + Profit = 23,000 + 40,000

QR = ---------------- -----------------------
- P – AVC 40 – 6.50

= 1880 . 6

The associated total revenue is

TR = PQ R = 40 (1880.6 ) = $ 75,224

3. If the price declines by 25% to $ 30, the new breakeven quantity

would be

Q e = 23,000
------------ = 978.7
30-6.50
The corresponding total revenue for this o/t rate is :

TR = 30 ( 978.7) = $ 29,361.

INTERNAL & EXTERNAL ECONOMIES & DISECONOMIES

 Economies of large – scale production

Internal External
Due to expansion of firm Due to expansion of Industry.
( increase in its size ) ( increase in the number of firms)
- enjoyed exclusively by expanding firms - enjoyed by all firms in common.
- costs are borne by the firm - costs are shared in common
which expands by all firms.

 INTERNAL ECONOMIES:

1. Managerial Economies – functional specialization at important levels

can be introduced, such as production management, sales management,
research section, designing section, accounts department etc.

2. Commercial Economies / Marketing Economies e.g. obtaining bulk raw

materials at lower prices & spreading over of marketing costs over a
large output.

3. Financial Economies : A big firm has more credibility & can easily raise
funds. Its requirement of working capital is met very easily & at a
substantially low cost.

4. Technical Economies – A firm choosing a bigger plant can use

superior techniques of production and reduce its average cost greatly
by increasing its output.

5. Risk – Spreading Economies: A big firm can reduce risks by spreading

them over a number of operations. Suppose there are 2 firms:

First firm’s K Investment = Rs. 10 cr

Second firm’s K Investment = Rs. 50 cr.

Loss = Rs. 1 cr

1st case, Loss = 10%

2nd case, Loss = 2%

- Risks are also reduced through:

Diversification of output

Diversification of markets

Diversification of suppliers i.e. ordering raw materials & inputs from

more than one supplier

EXTERNAL ECONOMIES
Following are some of the important external economies which accrue to the
firms & reduce their costs of production:

(i) Cheaper materials & capital equipment:

The expansion of an industry means that demand for various kinds of

materials & capital equipment required by it increases. This makes it
possible to produce them on a large scale by other industries. This large-
scale production lowers their costs of production & hence prices.

(ii) Technological external economies : when the whole industry expands, it

may lead to the discovery of new technical knowledge & in accordance
with that the use of improved & better machinery than before. This will
change the technical coefficient of production & will enhance the
productivity of the firms in the industry & will reduce their costs of
production

(iii) Development of skilled labour When an industry expands in an area,

the labour in that area is well accustomed to do the various productive
processes & learns a good deal from the experience.

(iv) Improved transportation & marketing facilities.

(v) Development of Industry information services : As an industry expands,

the firms may form a trade association that distributes information
regarding technical knowledge and market possibilities about the industry
through publication of trade & technical journals. The firms may jointly
set – up a central research institute which will be engaged in discovering
new improved techniques for the firms in the industry.

EXTERNAL DISECONOMIES

(i) Rise in the prices of raw materials and capital goods which are in short
supply.

(ii) Rise in the wages of skilled labour.

(iii) In the context of scarcity of resources, an industry will expand by

snatching away the resources from other industries. For this, it will bid
up their prices.

(iv) In the real world of scarcity, an expanding industry may create more
external diseconomies than external economies.