Lecture 5 - Friday, January 26, 2018

Sunday, February 11, 2018 8:29 PM

Producer Theory

Previously, we have studied the Market schedule, i.e. Price,

Quantity Supplied, Quantity Demanded etc.

Now, we will start the origin of Qs, as a part of managerial

economics.

Production Process

Input --> Processing --> Output The Entrepreneur puts a frame

and determines the quantities
Added Value
of inputs to provide quantities
Cost of Input (Creation of
Cost of Output of output, and also Costs
value)

Producer Theory: The act of production involves the

transformation of inputs to outputs.

What is the aim of the theory of production?

Production Function
It is the relation between the amount of Inputs and
amount of Outputs

Output is a function of Input

--> Output = fn(Input)

To increase the amount of Output:

1. Increase amount of input (Physical increase in input)
2. Increase the quality of inputs (Productivity driven
growth)

Keep in mind
1. Productivity driven growth is mainly concerned in
advancement in processing means, rather than
physically increasing the amount of inputs. Thus
productivity driven growth enables the economy to
generate a larger output using the same resources.
2. Enhancing the productivity of labors can only be
achieved by enhancing the education and medical
care.
3. Factors of production: Land - Labor - Capital
Generally Land is the most fixed factor of production,
and it is the last one to change, i.e. the land capacity
is full, and expanding the land is required. Follows
the Land the Capital and comes at last the Labor,
which is the most variable factor of production.
4. A new feasibility study takes place prior to the
expansion of the land. Feasibility studies are not only

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 expansion of the land. Feasibility studies are not only
involved in new projects, but in expansion as well.

Production Function
Full Capacity
Feasibility Long-run production function
Short-run production function
study
There will be at least 1 fixed factor of All the factors of production become variable in
production in quantity or amount quantity or amount

The length of the long-run production function is the time period

consumed until at least 1 factor of production becomes fixed again, i.e.
land expansion time.

We will be mostly concerned in studying the effect of changing the labor

factor on the output while keeping the other factors of production fixed.

3 important concepts
1. Total Product (TP)
2. Marginal Product (MP)
3. Average Product (AP)

1. Total Product
It is the amount of total output produced by inducing the labor factor
while keeping the capital and land factors fixed.
Total product would equate zero for zero labors, and then it increases
with the increase of labors until it reaches its peak at some point,
continuing in increasing the labors after that point will cause the
total product to diminish

2. Marginal Product
It is the extra output produced by inducing one additional labor,
keeping the capital and land factors fixed.
It specifically measures the effect and role of the added labor onto the
total product.
, where L is the number of Labors.

3. Average Product
It measures the role of each labor onto the total product by dividing
the Total Product on the number of Labors

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 Once I know the Labor (L) and Total Product (TP), I can deduce the
others (MP - AP)

Consider 1 labor working in a factory

Inflection Points
and doing all the work alone. (Phase 1)
By adding another labor the total job is
split onto 2 labors, making an increase
in the total product, and the added
labor made a huge difference in the
total product (Higher MP), but still 2
labors cannot do the whole works alone
(Phase 1).
By adding another labor, the total job
is split onto 3 labors, making an
increase in the total product, and the
added labor made also a huge
difference on the product. (Phase 1)
At some point the number of available
labors will be just fine (End of phase 1) ,
but still the total product can increase
by assigning more labors, so assigning
an additional labor will increase the
total product. However, his sole presence
hasn't made a huge difference in the
total product (Lower MP). (Phase 2)
Eventually at some point, where the
number of labors will exceed the
required jobs to do (Negative MP), the
total product will start to decrease.
(Phase 3)

Note that:
1. Although the MP is derived from the TP, actually it affects very much
the total product curve since it is very specific and measures the
change in the total product from inducing a unit labor.
From the curves above, we can notice the following:
a. In the first phase, where adding a unit labor has made a
significant change in the total product (Higher MP), the total
product was also rising very high (High Slope)
b. In the second phase, at some point where adding a unit labor has
made relatively minor changes in total product (Lower MP) as the
land and capital have been fully utilized, the total product was
rising but with lower slope
c. In the third phase, where total saturation has been reached and
adding a unit labor would exceed the required job (Negative MP),
the total product would start to decline
d. The total product reaches its maximum (peak point) at the last
positive MP
The above points explain the Law of Diminishing Returns
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The above points explain the Law of Diminishing Returns
The law of diminishing returns starts to take place in phase 2, and
continues in phase 3

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Stage of operation
Rational producers will tend to achieve the maximum Total product,
at the last positive MP, so they will tend to stop at the end of phase 2,
and not reaching phase 3, at which the total product starts to decline.
If they found out that they are already at phase 3, they should tend to
reduce the amount of Labors, in order to return back to achieving the
maximum total product, and achieving a positive MP instead of a
negative MP
At phase 1, keeping the land and capital fixed and the labor
variable, the Marginal Products of land and capital relative to the
labor are negative, which means there is still a place for adding more
labors and increasing the total product, so rational producers would
not stop at phase 1, and they would be confidently motivated to add
more labors in order to increase their own Total product.
➢ Rational Producers would stop adding labors at some point in phase 2

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Returns to Scale
Here we will study the effect of making all the factors of production
variable with the same proportion on the total product

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Screen clipping taken: 2/12/2018 2:11 PM

ing taken: 2/12/2018 2:12 PM

EX: Increase in
level of
technology, which
is indivisible

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 EX: weak
management,
which is
indivisible.

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