Running head: Empirical Estimation of Production Function

EMPIRICAL ESTIMATION OF PRODUCTION FUNCTION

(Take Home Assignment-01)

By

Ms. K.S. Tennakoon

(2009/MBA/WE/55)
Semester I – Second half
May 2010

Course: MBA 534 - Managerial Economics

Lecturer: Dr. N. Ravinthirakumaran

Postgraduate and Mid-Carrier Development Unit

Faculty of Management and Finance
University of Colombo
Empirical Estimation of Production Function 1

Contents
Abstract.................................................................................................................................................2
Introduction...........................................................................................................................................3
Production Function..............................................................................................................................3
Short Run Production Function.........................................................................................................5
Long Run Production Function..........................................................................................................5
Cost involvement in Production Process...............................................................................................6

Problems in estimating Production Function.........................................................................................7

Conclusion.............................................................................................................................................9
References...........................................................................................................................................10
Bibliography........................................................................................................................................10
Empirical Estimation of Production Function 2

Abstract
The main objective of all firms in today’s competitive business environment is to maximize
their profits. That is the major factor for them to survive. In order to do that they must use
the maximum that can be extracted from their scarce resources and other inputs and produce
optimal outputs. Production function helps this process to actually know how the inputs and
output are related and by what strength.
The document analyses this in the short run and long run and identifies some
problems that are faced when trying to formulate the same.

.
Empirical Estimation of Production Function 3

Introduction

There are three fundamental tasks of all firms that should be performed in an
exchange economy. First, a firm must obtain inputs. Inputs include raw materials, energy,
machinery, office space, workers, and anything else needed to produce output. Second, the
firm must combine or use inputs to produce output. Output may either be a tangible good
such as a pair of shoes or an automobile, or a service such as a haircut or a medical checkup.
Third, the firm must sell its output to someone else. A firm that cannot do these three tasks
well enough will not survive.
The economic theory of the firm is an analysis of the way the firm must perform these
three tasks to make a profit. Each task can be described in mathematical or graphical terms.
Supply curves of resources describe the first task. They indicate how much the firm must pay
for the amount of inputs it wants. The production function describes the second task. It tells
how much output the firm can produce from a set of inputs. The demand curve for output
describes the third task. It depends on people's wants or preferences and tells how much the
firm can charge for output. Each of these mathematical ways of representing the three
fundamental tasks can be seen as a constraint or limitation that the firm faces.

Production Function

The production function contains information about how much output can be obtained
with various quantities of inputs. The production function is often discussed as a relationship
between inputs and output, as its name implies. (Mathematically, a function is a special sort
of relationship.) However, it too can be discussed as a boundary. It shows the maximum that
can be produced with any combination of resources. Less than this maximum can be
produced; one can always get nothing for something. In an expression form it can be written
as; Q = f (K, L), where K, L are inputs for the manufacturing of the particular good or
service. Following are the three measures of production / productivity that are being used.

 Total product is simply the total output that is generated from the factors of
production employed by a business.
Empirical Estimation of Production Function 4

 Average product is the total output divided by the number of units of the variable
factor of production employed (e.g. output per worker employed or output per unit of
capital employed)

 Marginal product is the change in total product when an additional unit of the
variable factor of production is employed. For example marginal product would
measure the change in output that comes from increasing the employment of labour
by one person, or by adding one more machine to the production process in the short
run.

Following is the graphical representation of the same taking an example of a chair

manufacturing company.
[ CITATION Mic \l 1033 ]

We can identify two scenarios that the production function is explained at. That is, in
the short run and long run.
Empirical Estimation of Production Function 5

Short Run Production Function

The short run is defined in economics as a period of time where at least one factor of
production is assumed to be in fixed supply. It cannot be changed. We normally assume that
the quantity of capital inputs (e.g. plant and machinery) is fixed and that production can be
altered by suppliers through changing the demand for variable inputs such as labour,
components, raw materials and energy inputs. Often the amount of land available for
production is also fixed.
The time periods used are somewhat arbitrary because they differ from industry to
industry. The short run for the electricity generation industry or the telecommunications
sector varies from that appropriate for newspaper and magazine publishing and small-scale
production of foodstuffs and beverages. Much depends on the time scale that permits a
business to alter all of the inputs that it can bring to production.
In the short run, the law of diminishing returns states that as we add more units of a
variable input (labour or raw materials) to fixed amounts of land and capital, the change in
total output will at first rise and then fall.  Diminishing returns to labour occurs when
marginal product of labour starts to fall. This means that total output will still be rising, but
increasing at a decreasing rate as more workers are employed. As seen on the graphs above,
eventually a decline in marginal product leads to a fall in average product.
What happens to marginal product is linked directly to the productivity of each extra
worker employed. At low levels of labour input, the fixed factors of production; land and
capital, tend to be under-utilised which means that each additional worker will have plenty of
capital to use and, as a result, marginal product may rise. Beyond a certain point however, the
fixed factors of production become scarcer and new workers will not have as much capital to
work with so that the capital input becomes diluted among a larger workforce.
As a result, the marginal productivity of each worker tends to fall, this is known as the
principle of diminishing returns.   

Long Run Production Function

In the long run, all factors of production are variable. How the output of a business
responds to a change in factor inputs is called returns to scale.
 Increasing returns to scale occur when the % change in output > % change in inputs
 Decreasing returns to scale occur when the % change in output < % change in inputs
 Constant returns to scale occur when the % change in output = % change in inputs  
Empirical Estimation of Production Function 6

Cost involvement in Production Process

We can do mathematical prediction for the cost involvement in production cycle and
reduce the unnecessary cost components as well as optimize. Cost of production determines
the profit of a firm which can be generate and optimize the production process.
Cost of production has three parameters.
 Fixed Cost - Costs that the firm has to pay independently of whether it is
operating or not, e.g. rent on a building
 Variable Cost. Costs come from the inputs the firm uses in its production process,
e.g. the wages paid to laborers
 Total Cost - Sum of fixed and variable costs
To determine the optimal production point we can further go through with these
parameters.
 Marginal Cost - Defined as the change in Total Costs as quantity changes by one
unit. This will be the slope of Total Costs

ΔTC
MC=
Δy
Where is ΔTC the change in total costs and Δy is change in
quantity.
 Average Fixed Cost - Ratio of fixed costs over quantity produced. Average Fixed
Costs will tend to go to zero as the firm increases production.

FC
AFC =
Δy
Where FC are Fixed Costs and Δy is quantity produced.
 Average Variable Cost - Ratio of Variable Costs over quantity produced by the
firm.
VC
AVC=
Δy
Where VC is Variable Cost and is quantity produced by the firm.
 Average Total Cost - Summation of Average Fixed Costs and Average Variable
Costs.
The following is a graphical representation of the aforementioned parameters.
Empirical Estimation of Production Function 7

Problems in estimating Production Function

In most manufacturing industries such as motor vehicles, freezers and DVD players, it
is straight forward to measure the volume of production from labour and capital inputs that
are used. But in many service or knowledge-based industries, where much of the output is
“intangible” or perhaps weightless we find it harder to measure productivity.
If we take the Software Industry, the main input is the knowledge workers; the
engineers who make use of the brain power to produce technology solutions for various
requirements of other industries. Other than that the machinery (laptops, computers, hand-
held devices, printers, scanners etc), monetary capital are the main inputs. Then there is a
major problem at hand as can we really accurately estimate the amount of knowledge as a
numerical factor empirically, which contributes to the production function. But one can point
out that factors like “lines of code” or the time period that was spent could be taken as the
measurement.
Also brain storming sessions and discussions are vital factors which aids in providing
software solutions. It is basically through these numerous input from many employees’
judgments, that the final output is produced in desired quality. Therefore a question arises
how we give valuation through the production function for inputs such as the same.
Another area that we can observe as a problem is; there exists significant price
dispersion in many industries. As a consequence the value of output is not necessarily a good
measure of the quantity of output. Estimation of production functions for these types of goods
Empirical Estimation of Production Function 8

is thus challenging since quantities and prices of output are typically not separately observed
by the econometrician. Estimating production functions for housing and on the car repair
service industry can be taken as examples for this aspect. [ CITATION Epp06 \l 1033 ]
Empirical Estimation of Production Function 9

Conclusion

Production function plays a vital role in the business world today in identifying the
way that inputs can be used maximally for getting the best out of them to produce large
outputs, and thereby maximize profits. This is a true factor for new businesses as well as
existing industries as well. As the environmental factors change the production function
needs to be reevaluated to formulate a better suited formula.
But as identified above, there are problems which we face trying to formulate the
same. By doing proper analysis and by making rational decisions it is possible to make a
more realistic production function which will help the particular industry to rise above its
competitors.
Empirical Estimation of Production Function 10

References
Epple, D., Gordon, B., & Sieg, H. (2006, July). A Flexible Approach to Estimating
Production Functions.

Microeconomics. (n.d.). Retrieved from

http://www.compilerpress.ca/ElementalEconomics/mic_3_3.htm

Riley, G. (2006, September). Microeconomics - Short Run and Long Run Production.
Retrieved from http://tutor2u.net/economics/revision-notes/a2-micro-shortrun-longrun-
production.html

Bibliography
Keat/Young. (2003). Managerial Economics, 4th Edition. Prentice Hall Business Publishing.