Production theory

Provides framework for

economics of production of
firm
Manager in Production Process
 To ensure that the firm operates on the
production process

 To ensure that the firm uses the correct

levels of inputs
 The Organization of Production
 Inputs
 Labor, Capital, Land
 Fixed Inputs
 Variable Inputs
 Short Run
 At least one input is fixed
 Long Run
 All inputs are variable
What is production
 Production refers to transformation of
inputs or resources into outputs of goods
and services

 Inputs = resources used in production of

goods (fixed and variable)
 Output = end result
Basic production decision
1.How much of commodity to produce
2.How much inputs should be used

To answer these questions, the firm

a. Requires engineering data on production
possibilities
b. Economic data on input and output prices
Production function
 Production is a function that transforms
inputs into output
Q = f (L, N, K……T)

Factors affecting production are

1.Technology
2.Inputs (land, labour etc)
3.Time period (short run vz long run)
Production function with one variable
input

1) Total Product: TP = Q = f(L)

TP
2) Average Product: APL =
L
TP
3) Marginal Product: MPL =
L
4) Production or MPL
Output Elasticity: EL =
APL
Concepts of production
 Total Product :This is amount of total
output produced by a given amount of
factor, other factors held constant.
 Average Product:This is total output
produced per unit of factor employed
AP =TP/no.of units of factor employed

Marginal Product:This is addition to total

production by employment of extra unit of
factor
Law of variable proportions or law of
diminishing returns
 As more and more of one factor input is
employed, all other input quantities held
constant, a point will be reached where
additional quantities of varying input will
yield diminishing marginal contribution to
total product
 Short run law
 Some factors fixed, other factors variable
 State of technology fixed and unchanged
 Possibility of varying proportion of factors
 PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

TABLE 6.1 Production with One Variable Input

Amount Amount Total Average Marginal
of Labor (L) of Capital (K) Output (q) Product (q/L) Product
0 10 0 — ∆L)
(∆q/—
1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 4
10 10 100 10 8
Production function with one variable
input
Stages of return
Stage 1:Increasing returns. MP increasing,
AP increasing, TP increases till G at
increasing rate, after that at decreasing
rate. G= point of inflexion
Stage 2:Diminishing returns. MP decreasing
and falls till zero, AP decreasing, TP
increases at a decreasing rate
Stage 3:Negative returns. MP negative, AP
decreasing, TP is also falling
Contd..
 Stage of operations –stage2
 Stage 1 – fixed factor too much for
variable factor. Fixed factor is more
intensively utilised
 Stage 3- variable factor too much in
relation to fixed factor

 Applications – agriculture, studying

 PRODUCTION WITH ONE VARIABLE INPUT (LABOR)
 The Law of Diminishing Marginal Returns
● law of diminishing marginal returns Principle that as the use
of an input increases with other inputs fixed, the resulting
additions to output will eventually decrease.

Figure 6.2

The Effect of Technological

Improvement
Labor productivity (output per
unit of labor) can increase if
there are improvements in
technology, even though any
given production process
exhibits diminishing returns to
labor.
As we move from point A on
curve O1 to B on curve O2 to C
on curve O3 over time, labor
productivity increases.
Numerical
 Suppose that a tailor working alone can make 2
suits per month; 2 tailors working in the same
shop can produce 5 suits; 3 tailors 10 suits; 4
tailors 14 suits; 5 tailors 17 suits; 6 tailors 19
suits;
 a. Find MP of labour
 b. When does the law of diminishing return begin
to operate? Why do you have increasing returns
up to that point?
 c. Why do diminishing returns eventually set in?
Production function with one variable
input
Total, Marginal, and Average Product of Labor, and Output Elasticity

L Q MPL APL EL
0 0 - - -
1 3 3 3 1
2 8 5 4 1.25
3 12 4 4 1
4 14 2 3.5 0.57
5 14 0 2.8 0
6 12 -2 2 -1
Optimal use of variable input

Marginal Revenue
MRPL = (MPL)(MR)
Product of Labor
Marginal Resource TC
MRCL =
Cost of Labor L

Optimal Use of Labor MRPL = MRCL

Optimal use of variable input

Use of Labor is Optimal When L = 3.50

L MPL MR = P MRPL MRCL
2.50 4 $10 $40 $20
3.00 3 10 30 20
3.50 2 10 20 20
4.00 1 10 10 20
4.50 0 10 0 20
Optimal use of variable input
Production with two variable inputs
Isoquants show combinations of two inputs
that can produce the same level of output.

Firms will only use combinations of two

inputs that are in the economic region of
production, which is defined by the portion
of each isoquant that is negatively sloped.
Production function with 2 inputs
Q = f(L, K)
K Q
6 10 24 31 36 40 39
5 12 28 36 40 42 40
4 12 28 36 40 40 36
3 10 23 33 36 36 33
2 7 18 28 30 30 28
1 3 8 12 14 14 12
1 2 3 4 5 6 L
Production Function
With Two Inputs
Discrete Production Surface
Isoquant
 An isoquant is a curve representing
various combinations of 2 inputs that
produce the same level of output

 ISO+QUANT= same + quantity

Production Function
With Two Inputs

Continuous Production Surface

Production with two variable inputs

Isoquants
Production with two variable inputs

Economic
Region of
Production
Production with two variable inputs

Marginal Rate of Technical Substitution

MRTS = -K/L = MPL/MPK

Marginal rate of substitution

 The marginal rate of technical substitution

of L for K (MRTS lk) is the amount of K a
firm will give up for increasing the amount
of L used by 1 unit and remain on same
isoquant

MRTS lk = MP l = w
MP k r
Production With Two
Variable Inputs
MRTS = (-2.5/1) = 2.5
Production with two variable inputs
Perfect Substitutes Perfect Complements
Optimal combination of inputs
Isocost lines represent all combinations of
two inputs that a firm can purchase with
the same total cost.

C  wL  rK C  Total Cost
w  Wage Rate of Labor ( L)
C w
K  L r  Cost of Capital ( K )
r r
Isocost
 An isocost shows all different combinations
of labor and capital that a firm can
purchase, given the total outlay (TO) of
firm and factor prices.

 The slope of an isocost is – Pl.

Pk
Producer’s equilibrium
 An producer is in equilibrium when he
maximises output for total outlay.
 i.produces given output at minimum cost
 ii. Produces maximum output at given level of
cost

 Equilibrium = isocost tangent to isoquant

 Here, MRTS lk = MPl /MPk = w/r

 i.e.At equilibrium, MPl = MPk

 Pl Pk
Optimal combination of inputs
MRTS = w/r
Returns to Scale- Change in all inputs

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.
Stages of return – Returns to scale
 The percentage increase in output when all inputs
vary in same proportion is known as returns to
scale
1.Constant returns to scale – Output increases in
same proportion as increase in input
2.Increasing returns to scale-Output increases by
greater proportion as increase in input
3. Decreasing returns to scale – Output increases
by lesser proportion as increase in input
Returns to Scale
Constant Increasing Decreasing
Returns to Returns to Returns to
Scale Scale Scale
Reasons
Causes of increasing returns
Specialisation in large scale production. In
some industries, small scale production is
not possible

Causes of decreasing returns

Coordination and control maybe difficult.
Information maybe lost or distorted when
transmitted
Production data of Silicone chip firm
L K % inc L, K Q % inc TP Returns
1 100 - 100 0 increase
2 200 100 220 120 increase
3 300 50 350 59 increase
4 400 33.33 500 42.9 increase
5 500 25 625 25 constant
6 600 20 750 20 constant
7 700 16.66 860 14.66 decrease
8 800 14.29 940 9.3 decrease
9 900 12.5 1000 6.4 decrease
Effect of technology
 What is the effect of technology on
production?
 How do isoquants change?
Innovations, Global Competition
 Product Innovation
 Process Innovation
 Product Cycle Model
 Just-In-Time Production System
 Competitive Benchmarking
 Computer-Aided Design (CAD)
 Computer-Aided Manufacturing (CAM)
Elasticity of Substitution
 When price of a factor falls, the equilibrium
position will be disturbed. The producer will
substitute the cheaper factor for other factor. The
degree of substitutability of factor L for factor K,
resulting exclusively from change in relative
factor prices, is called elasticity of technical
substitution.
 E subs = Δ(K/L)/(K/L)
 Δ(MRTS)/(MRTS)