1. Economics of Pricing Strategies Faculty: Prof. Sunitha Raju Production Analysis - I Session Date:13.01.2013

2. PGDIBS 2012-13 Economics of Pricing Strategies 1.Defining Production Function  Production is physical transformation of input resources into goods & services Inputs → Process → Output  Production function defines the technical relationship between production inputs and output Basic Production Concepts Contd…

3. PGDIBS 2012-13 Economics of Pricing Strategies 2.Inputs  Based on relationship with output, broadly categorise all inputs into  Fixed inputs (Capital) : same level of input irrespective of output level (eg : Machinery)  Variable input (Labour) : Varies with output level Q= f (L, K)  how do changes in input level influence the changes in output level Basic Production Concepts Contd…

4. PGDIBS 2012-13 Economics of Pricing Strategies 3.Long Run vs Short Run  Short run  When Production decisions are defined by a given capacity/capital/technology  Fixed and variable inputs together production determine production. decision relates to how much to produce under a given capacity Contd… Basic Production Concepts

5. PGDIBS 2012-13 Economics of Pricing Strategies  Long run  When Production decisions are not constrained by a given technology/capacity  Number of technological options exist. As such, no fixed inputs  Production decision relates to identifying optimum capacity/scale of operation. Basic Production Concepts

6. PGDIBS 2012-13 Economics of Pricing Strategies 4.Defining Production Process  A product can be produced by various techniques/methods of production  A method in which various inputs are combined is defined by a ‘Process’ or ‘Technique’ (P) P1P2P3 L235 K324 Output is same but methods of input combination differs. Basic Production Concepts Contd…

7. PGDIBS 2012-13 Economics of Pricing Strategies Technically efficient process P1P2 L23 K33 P1 is technically efficient as less L used compared to P2 P1P2 L21 K34 P1 and P2 are not comparable and both considered as technically efficient Contd… Basic Production Concepts

8. PGDIBS 2012-13 Economics of Pricing Strategies  Efficient process Amongst the technically efficient processes, the least cost process is defined as Economically efficient process. Contd… Basic Production Concepts

9. PGDIBS 2012-13 Economics of Pricing Strategies Short Run Production Function  A production function defines all technical efficient input-output combinations  Any improvement in technology results in new production function. eg: better equipment productivity enhancing training

10. PGDIBS 2012-13 Economics of Pricing Strategies Run Production Decisions Short Run Production Decisions 1.Case of one variable input Q = f (L, K ) a)Decision on output/input level b)defining technically efficient level of output c)defining economically efficient level of output  Together (a), (b) & (c) will determine ‘how much’ output (Q) to produce and ‘how much’ inputs to use.

11. PGDIBS 2012-13 Economics of Pricing Strategies ABC Company: Total Output and Input Relations Amount of Machine Tools (Fixed) Amount of LabourTotal Output 500 5112 5227 5342 5456 5568 5676 57 5874

12. PGDIBS 2012-13 Economics of Pricing Strategies ABC Company: Average and Marginal of Labour ABC Company: Average and Marginal Products of Labour Amount of Machine Tools (Fixed) Amount of Labour Total OutputAverage Products of Labour 500- 511212.0 522713.5 534214.0 545614.0 556813.6 567612.7 577610.9 58749.2

13. PGDIBS 2012-13 Economics of Pricing Strategies ABC Company: Average and Marginal of Labour ABC Company: Average and Marginal Products of Labour Amount of Machine Tools (Fixed) Amount of Labour Total Output Average Products of Labour Marginal Product of Labour 500-- 511212.012 522713.515 534214.015 545614.014 556813.612 567612.78 577610.90 58749.2-2

14. PGDIBS 2012-13 Economics of Pricing Strategies ABC Company: Average and Marginal of Labour ABC Company: Average and Marginal Products of Labour Amount of Machine Tools (Fixed) Amount of Labour Total Output Average Products of Labour Marginal Product of Labour MRP L 500--- 511212.01260 522713.51575 534214.01575 545614.01470 556813.61260 567612.7840 577610.90 58749.2-2 Assume MR = 5 P L = 60

15. PGDIBS 2012-13 Economics of Pricing Strategies  Decision on how much Q to produce  As long as MP L is positive  Marginal Revenue Product (MRP L ) → MRP L ≥ = P L = MRP L = = MR L. MP L = P L  Corresponds to Q = 68 and L = 5 L P L Q Q TR     .

16. PGDIBS 2012-13 Economics of Pricing Strategies Problem Solving 1 Tax Advisors Inc. has an office for processing tax returns in Pennsylvania. The following table shows how many tax returns are processed per hour as the number of CPA (Certified Public Accountants) employed increases CPAs (L)Tax returns processed / hour 10.2 21.0 32.4 42.8 53.0 62.7 1.Should the firm engage the 4 th CPA? What should be the optimum number of CPAs to be engaged? 2.If the CPA’s earn $35 per hour and the revenue for each tax return processed is $100, should the firm employ the 4 th CPA.

17. PGDIBS 2012-13 Economics of Pricing Strategies 1. Given a production function  Under conditions of recession (output prices are falling), a firm decides to produce where AP L max  Under conditions of boom (output prices are rising), a firm produces until MRP L ≥ PL Conceptualize the rising managerial salaries Production Decisions : Dimensions Contd…

18. PGDIBS 2012-13 Economics of Pricing Strategies 2. Case of more than one variable input  Efficient combination of inputs  Methodology used is Isoquant Production Decisions : Dimensions

19. PGDIBS 2012-13 Economics of Pricing Strategies Isoquants 23456 1 2 3 4 5 L1L1 L2L2 3 1 7 10 12 6 10 8 18 23 28 24 12 28 33 36 31 14 30 36 40 42 12 28 33 36 40 39  Isoquants show combination of two inputs that can produce same level of outputs Short run Production Function : Efficient Combination of Inputs

20. PGDIBS 2012-13 Economics of Pricing Strategies Isoquants 2345 1 2 3 4 5 L1L1 L2L2 3 1 7 10 12 6 10 8 18 23 24 12 33 31 14 30 40 42 12 33 36 40 39 28 36  Isoquants show combinations of two inputs that can produce same level of outputs

21. PGDIBS 2012-13 Economics of Pricing Strategies  Substitution between L 1 and L 2 is determined by marginal productivities of L 1 and L 2  Marginal rate of technical substitution (MRTS) = =  The rate of substitutability between inputs is defined by the shape of Isoquant (ratio of MP L ) L1L1 L2L2 Q1Q1 Q2Q2 Q3Q3

22. PGDIBS 2012-13 Economics of Pricing Strategies Isoquant L1L1 L1L1 L1L1 L 1 and L 2 are not perfect substitutes L2L2 L2L2 L2L2 L 1 and L 2 are perfect substitutes L 1 and L 2 are complementary

23. PGDIBS 2012-13 Economics of Pricing Strategies Isocost  Isocost show the different combinations of inputs (at given prices) For the same cost outlay. L1L1 L2L2 Any point on Isocost reflects the price ratio of L 1 and L 2

24. PGDIBS 2012-13 Economics of Pricing Strategies Efficient Combination of Inputs    .

25. PGDIBS 2012-13 Economics of Pricing Strategies Efficient Combination of inputs Effect of a change in Input Price Q2Q2 L1L1 L2L2 L2L2 L2L2 L1L1 L1L1

26. PGDIBS 2012-13 Economics of Pricing Strategies Problem Solving Medical Testing Labs, Inc., provides routine testing services for blood banks in the Los Angeles area. Tests are supervised by skilled technicians using equipment produced by two leading competitors in the medical equipment industry. Records for the current year show an average of 27 tests per hour being performed on the Test logic-1 and 48 tests per hour on a new machine, the Accutest-3. The Testlogic-1 is leased for $18,000 per month and the Accutest-3 is leased at $32,000 per month. On average, each Machine is operated 25 days of 8 hours each. 1.Does the Lab usage reflect optimal mix of Testlogic-1 and Accutest-3. 2.If the price of tests conducted at the Lab is $6, should the company lease more machines.

27. PGDIBS 2012-13 Economics of Pricing Strategies Long Run Production Function  Scale of operation is another source for cost minimization  Identifying optimal scale of operation for a given demand conditions

28. PGDIBS 2012-13 Economics of Pricing Strategies  Long run Production Function Q = f (L, K)  Where scale increases, then  output increases (Increasing Returns to Scale) by a greater proportion  output increases (Constant Returns to Scale) by the same proportion  output increases (Decreasing Returns to Scale) by a lesser proportion

29. PGDIBS 2012-13 Economics of Pricing Strategies Production Function Q = f(L, K) Q = f (hL, hK) If = h, then f has constant returns to scale. If > h, then f has increasing returns to scale. If < h, the f has decreasing returns to scale.