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PRODUCTION

Production theory forms the foundation for

the theory of supply

Managerial decision making involves four

types of production decisions:

1. Whether to produce or to shut down

2. How much output to produce

3. What input combination to use

4. What type of technology to use

Production involves transformation of

inputs such as capital, equipment, labor,

and land into output - goods and services

Production theory can be divided into

short run theory or long run theory.

Long run and short run:

The Long Run is distinguished from the short run

by being a period of time long enough for all

inputs, or factors of production, to be variable as

far as an individual firm is concerned

The Short Run, on the other hand, is a period so

brief that the amount of at least one input is fixed

The length of time necessary for all inputs to be

variable may differ according to the nature of the

industry and the structure of a firm

Production Function

A production function is a table or a mathematical

equation showing the maximum amount of output

that can be produced from any specified set of

inputs, given the existing technology. The total

product curve for different technology is given

below.

Q

Q = output

x = inputs

x

Production Function continued

where

Q = output

X1, …, Xk = inputs

inputs to two, capital (K) and labor (L):

Q = f(L, K)

DEFINITIONS:

In the short run, capital is held constant.

Average product is total product divided by

the number of units of the input

Marginal product is the addition to total

product attributable to one unit of variable

input to the production process fixed input

remaining unchanged.

MP = TPN – TPN-1

Short run

labour Total product Average Marginal

product product

1 10 10 10

2 24 12 14

3 39 13 15

4 52 13 13

5 61 12.2 9

6 66 11 5

7 66 9.4 0

8 64 8 -2

Marginal and Average product:

Marginal product at any point is the slope of

the total product curve

Average product is the slope of the line

joining the point on the total product curve to

the origin.

When Average product is maximum, the

slope of the line joining the point to the origin

is also tangent to it.

P: Maximum Average Product

Q & R : Same Average Product

Both AP and MP first rise, reach a maximum

and then fall.

MP = AP when AP is maximum.

MP may be negative if Variable input is used

too intensively.

Law of diminishing marginal

productivity states that in the short run if

one input is fixed, the marginal product of the

variable input eventually starts falling

Law of Diminishing Returns

(Diminishing Marginal Product)

diminishing returns says that:

As additional units of a variable input are

combined with a fixed input, at some point the

additional output (i.e., marginal product) starts to

diminish

e.g. trying to increase labor input without also

increasing capital will bring diminishing returns

Three stages of production:

Stage 1: Till average product becomes

maximum

Stage 2: till MP =zero

Stage 3: MP is negative

Three Stages of Production in Short

Run

AP,MP

Stage I Stage II Stage III

APX

MPX X

Section 2:

Production in the Long-Run

All inputs are now considered to be variable

(both L and K in our case)

How to determine the optimal combination of

inputs?

isoquants.

An isoquant is a curve showing all possible

combinations of inputs physically capable of

producing a given fixed level of output.

45

An isoquant

a

40 Units Units Point on

of K of L diagram

35

40 5 a

30 20 12 b

Units of capital (K)

10 20 c

25 6 30 d

20

4 50 e

b

15

10

c

5

d

0

0 5 10 15 20 25 30 35 40 45 50

fig

Isoquants and the Production Function

combinations of two inputs that will produce a given

level of output

Slope of an isoquant indicates the rate at which

factors K and L can be substituted for each other while

a constant level of production is maintained.

The slope is called Marginal Rate of Technical

Substitution (MRTS)

Properties of Isoquants

the firm could possibly produce with isoquants

farther from the origin indicating higher rates of

output

employed is inversely related to the quantity of

capital employed isoquants have negative

slopes

Properties of Isoquants

Isoquants do not intersect. Since each isoquant

refers to a specific rate of output, an intersection

would indicate that the same combination of

resources could, with equal efficiency, produce

two different amounts of output

isoquant gets flatter as we move down along the

curve

Substitutability of Inputs

isoquant might have are:

• The isoquants are right angles, indicating

that inputs a and b must be used in fixed

proportions and therefore are not

substitutable

e.g Yeast and flour for a specific type of bread

Substitutability of Inputs

b) Perfect Substitutes – in this case input a can be

substituted for input b at a fixed rate as indicated by

the straight line isoquants (which have a constant

slope and MRS)

Ie. Honey and brown sugar are often nearly perfect

substitutes, Natural gas and fuel oil are close

substitutes in energy production

Isoquant Maps for Perfect Substitutes

and Perfect Complements

Substitutability of Inputs

c) Imperfect Substitutes – and the rate at which input b

can be given up in return for one more unit of input a

while maintaining the same level of output (the MRS)

diminished as the amount of input a being used

increases

Ie. In farming, harvestors and labour for harvesting

grain provide an example of a diminishing MRS, and

in general capital and labour are imperfect

substitutes.

The Marginal Rate

of Technical Substitution

Marginal Rate of Technical Substitution

The absolute value of the slope of the isoquant is

the marginal rate of technical substitution, MRTS,

between two resources

substitutes for capital without affecting output

when much capital and little labor are used, the

marginal productivity of labor is relatively great and

the marginal productivity of capital relatively small

one unit of labor will substitute for a relatively

large amount of capital

Law of Diminishing Marginal

Rate of Technical Substitution:

Table 7.8 Input Combinations

for Isoquant Q = 52

Combination L K

A 6 2

B 4 3

C 3 4

D 2 6

E 2 8

Marginal Rate of Technical Substitution

If labor and capital were perfect substitutes in

production, the rate at which labor substituted for

capital would remain fixed along the isoquant

the isoquant would be a downward sloping

straight line

Summary

Isoquants farther from the origin represent higher

rates of output

Isoquants slope downward

Isoquants never intersect

Isoquants are bowed toward the origin

Marginal Rate of Technical Substitution

Anywhere along the isoquant, the marginal rate

of technical substitution of labor for capital

equals the marginal product of labor divided by

the marginal product of capital, which also equals

the absolute value of the slope of the isoquant

Isocost Lines

Isocost lines show different combinations of inputs

which give the same cost

At the point where the isocost line meets the vertical

axis, the quantity of capital that can be purchased

equals the total cost divided by the monthly cost of a

unit of capital TC / r

Where the isocost line meets the horizontal axis, the

quantity of labor that can be purchased equals the total

cost divided by the monthly cost of a unit of labor

TC / w

The slope of the isocost line is given by

Slope of isocost line = -(TC/r)/(TC/w) = -w/r

Choice of Input Combinations

The profit maximizing firm wants to produce its chosen

output at the minimum cost it tries to find the isocost

closest to the origin that still touches the chosen

isoquant.

two inputs that can be bought for a given dollar cost.

The equation for an isocost line is:

C = PL + PK

Maximizing Output for a given cost

MPL w

MRTS LK = =

MPK r

Minimizing Cost subject to given Output

Expansion Path

If we imagine a set of isoquants representing

each possible rate of output, and given the

relative cost of resources, we can then draw

isocost lines to determine the optimal

combination of resources for producing each rate

of output

Expansion Path leads to Total Cost Curve

An expansion path is a long-run concept

(because all inputs can change)

Each point on the expansion path

represents a cost-minimizing combination

of inputs

Given input prices, each point represents

a total cost of producing a given level of

output when the entrepreneur can choose

any input combination he or she want

Expansion Path

If the relative prices of resources change, the

least-cost resource combination will also change

the firm’s expansion path will change

capital becomes relatively less expensive the

efficient production of any given rate of output

will therefore call for less labor and more capital

Returns to Scale

Is large scale production more efficient than

small scale production for a certain market?

Is a market better served by many small

firms or a few large ones?

relationship between scale and efficiency.

Returns to Scale

The returns to scale concept is an inherently

long run concept.

function for which any given proportional

change in all inputs leads to a more than

proportional change in output.

Returns to Scale

Constant returns to scale : a production function for

which a proportional change in all inputs causes

output to change by the same proportion.

which a proportional change in all inputs causes a

less than proportional change in output.

The Distinction between Diminishing

Returns and Decreasing Returns to

Scale

Diminishing returns to scale is a short run

concept that refers to the case in which one

input varies while all others are held fixed.

concept that refers to the case in which all

inputs are varied by the same proportion.

4

Constant returns to scale

R

3

c

600

Units of capital (K)

2

b 500

1

400

a

0 300

0 1 2 3

200

fig

4 Increasing returns to scale (beyond

point b) R

3

c

700

Units of capital (K)

600

2

b

500

1

400

a

0 300

0 1 2 3

200

fig

4 Decreasing returns to scale

(beyond point b) R

3

c

500

Units of capital (K)

2

b

1

400

a

0 300

0 1 2 3

200

fig

Returns to Scale Shown on the Isoquant

Map

Economic Region of Production

There are certain combinations of inputs that the firm

should not use in the long run no matter how cheap

they are (unless the firm is being paid to use them)

These input combinations are represented by the

portion of an isoquant curve that has a positive slope

Economic Region of Production

A positive sloped isoquant means that merely to

maintain the same level of production, the firm must

use more of both inputs if it increases its use of one

of the inputs

The marginal product of one input is negative, and

using more of that input would actually cause output

to fall unless more of the other input were also

employed.

Economic Region of Production

Ridge Lines – are lines connecting the points where

the marginal product of an input is equal to zero in

the isoquant map and forming the boundary for the

economic region of production

Economic Region of Production – is the range in

an isoquant diagram where both inputs have a

positive marginal product. It lies inside the ridge lines

Homogeneous Production function:

If both factors of production are increased by

proportion λ, and if new level of output Q*

can be expressed as a function of λ to any

power v, and the initial output ,

i.e. Q* = λV Q

then the function is homogeneous and v is the

degree of homogeneity.

For example , check the function Q = 4L+3K2

If the production function is homogeneous ,

the expansion path is a straight line.

Check the homogeneity of the following

functions:

Q = 4L +3K

Q= 4KL

Q =4KL+K

A simple production function is the

Cobb-Douglas form

Three parameters: A, , and

α β

q =A⋅ L K

The Cobb-Douglas production function has CRS if

+=1

The Cobb-Douglas production function has increasing

(decreasing) returns to scale if +

If ==½, we have the square root production

function

ISOCLINE:

An isocline is a locus of points along which

MRTS is constant.

An expansion path is also an isocline.

An isocline is a straight line if the production

function is homogeneous

Cobb – Douglas Production Function:

Q =AKαLβ

If α+ β=

1 , we have CRS

> 1 , we have IRS

< 1, we have DRS

Check Q = L2K2

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