Ch 4 THE THEORY OF 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

Ch 5 Ch 4

Production involves transformation of inputs such as capital, equipment, labor, and land into output - goods and services In this production process, the manager is concerned with efficiency in the use of the inputs
- technical vs. economical efficiency

Two Concepts of Efficiency

Economic efficiency:

occurs when the cost of producing a given output is as low as possible

Technological efficiency:

occurs when it is not possible to increase output without increasing inputs

The objective of efficiency will provide us with some basic rules about the manner in which firms should utilize inputs to produce goods and services

You will see that basic production theory is simply an application of constrained optimization:
the firm attempts either to minimize the cost of producing a given level of output or to maximize the output attainable with a given level of cost. Both optimization problems lead to same rule for the allocation of inputs and choice of technology

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
f2(x) Improvement of technology f1(x) f (x) - f (x) 0 2 f0(x) Q = output x = inputs

Production Function

continued

Q = f(X1, X2, , Xk) where Q = output X1, , Xk = inputs

For our current analysis, lets reduce the inputs to two, capital (K) and labor (L):

Q = f(L, K)

Production Table
Units of K Em ploy d e 8 7 6 5 4 3 2 1 O utput Q ntity (Q ua ) 83 96 107 117 78 90 101 110 64 73 82 90 58 67 75 82 52 60 67 73 41 52 58 64 29 39 47 52 14 20 27 24 3 4 5 6 Units of L Em ploy d e

37 42 37 31 24 17 8 4 1

60 64 52 47 39 29 18 8 2

127 119 97 89 79 69 56 21 7

128 120 104 95 85 73 52 17 8

Same Q can be produced with different combinations of inputs, e.g. inputs are substitutable in some degree

 All of these outputs are assumed to

be technically efficient

But which one is economically efficient?

That

is the question facing the DM

Types of Production Functions

Production function with one variable input Production function with two variable inputs Production function with all variable inputs

Short-Run and Long-Run Production

In the short run some inputs are fixed and some variable

e.g. the firm may be able to vary the amount of labor, but cannot change the amount of capital in the short run we can talk about factor productivity

In the long run all inputs become variable

e.g. the long run is the period in which a firm can adjust all inputs to changed conditions in the long run we can talk about returns to scale (compare latter with economies of scale, which is a cost related concept)

Short-Run Changes in Production Factor Productivity

Units of K Employed 8 7 6 5 4 3 2 1 37 42 37 31 24 17 8 4 1 60 64 52 47 39 29 18 8 2 Output Quantity (Q) 83 96 107 117 127 128 78 90 101 110 119 120 64 73 82 90 97 104 58 67 75 82 89 95 52 60 67 73 79 85 41 52 58 64 69 73 29 39 47 52 56 52 14 20 27 24 21 17 3 4 5 6 7 8 Units of L Employed

How much does the quantity of Q change, when the quantity of L is increased?

Long-Run Changes in Production Returns to Scale

U its of K n E p e m loy d 8 7 6 5 4 3 2 1 3 7 4 2 3 7 3 1 2 4 1 7 8 4 1 6 0 6 4 5 2 4 7 3 9 2 9 1 8 8 2 8 3 7 8 6 4 5 8 5 2 4 1 2 9 1 4 3 O tp t Q a tity (Q u u un ) 9 6 17 17 0 1 9 0 11 10 0 1 7 3 8 2 9 0 6 7 7 5 8 2 6 0 6 7 7 3 5 2 5 8 6 4 3 9 4 7 5 2 2 0 2 7 2 4 4 5 6 U its of L E p e n m loy d 17 2 19 1 9 7 8 9 7 9 6 9 5 6 2 1 7 18 2 10 2 14 0 9 5 8 5 7 3 5 2 1 7 8

How much does the quantity of Q change, when the quantity of both L and K is increased?

Relationship Between Total, Average, and Marginal Product: Short-Run

Analysis

Total Product (TP) = total quantity of output Average Product (AP) = total product per total input Marginal Product (MP) = change in quantity when one additional unit of input used

The Marginal Product of Labor

The marginal product of labor is the increase in output obtained by adding 1 unit of labor but holding constant the inputs of all other factors Marginal Product of L: MPL= Q/ L (holding K constant) = Q/ L Average Product of L: APL= Q/L (holding K constant)

Short-Run Analysis of Total, Average, and Marginal Product

If MP > AP then AP is rising If MP < AP then AP is falling MP = AP when AP is maximized TP maximized when MP = 0

Law of Diminishing Returns

(Diminishing Marginal Product)
Holding all factors constant except one, the law of 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

Nothing says when diminishing returns will start to take effect, only that it will happen at some point All inputs added to the production process are exactly the same in individual productivity

Three Stages of Production in Short Run

AP,MP

Stage I

Stage II

Stage III

APX Fixed input grossly underutilized; specialization and teamwork cause AP to increase when additional X is used Specialization and teamwork continue to result in greater output when additional X is used; fixed input being properly utilized MPX Fixed input capacity is reached; additional X causes output to fall

Q u a n t i t y

Stage-1

Stage-2

Stage-3

TP Increasing Return Decreasing Return Negative Return AP L1 L2 L3 MP

Input-L
Stage-2 is rational and Stage-1 and 3 are irrational

How to Determine the Optimal Input Usage

We can find the answer to this from the concept of derived demand The firm must know how many units of output it could sell, the price of the product, and the monetary costs of employing various amounts of the input L Let us for now assume that the firm is operating in a perfectly competitive market for its output and its input

Example 1:

Note: P = Product Price = $2 W = Cost per unit of labor = $10000 TRP = TP x P, MRP = MP x P TLC = X x W MLC = TLC / X

T a b le 7 .6 C o m b in in g M a r g in a l R e v e n u e P r o d u c t (M R P ) w ith M a r g T o ta l M a rg i n a T o ta l M a rg in a l l L a b o r T o ta l A ve ra gM a rg in R le v e n u ee ve n u L a b o r L a b o r e a R e U n i t P ro d u cP ro d u cP ro d u cP ro d u cPt ro d u c tC o s t C o s t t t t (X ) (Q o r T P (A P ) (M P ) (T R P ) (M R P ) (T L C ) (M L C ) T R P -T L M R P -M L ) C 0 0 0 0 0 0 0 1 10000 10000 10000 200002000010000 10000 10000 10000 2 25000 12500 15000 500003000020000 10000 30000 20000 3 45000 15000 20000 900004000030000 10000 60000 30000 4 6 0 0 0 0 1 5 0 0 0 1 5 0 0 0 1 2 0 0 0 03 0 0 0 0 4 0 0 0 0 1 0 0 0 0 8 0 0 0 0 2 0 0 0 0 5 7 0 0 0 0 1 4 0 0 0 1 0 0 0 0 1 4 0 0 0 02 0 0 0 0 5 0 0 0 0 1 0 0 0 0 9 0 0 0 0 1 0 0 0 0 6 7 5 0 0 0 1 2 5 0 0 5 0 0 0 1 5 0 0 0 01 0 0 0 0 6 0 0 0 0 1 0 0 0 0 9 0 0 0 0 0 7 7 8 0 0 0 1 1 1 4 3 3 0 0 0 1 5 6 0 0 06 0 0 0 7 0 0 0 0 1 0 0 0 0 8 6 0 0 0 -4 0 0 0 8 8 0 0 0 0 1 0 0 0 0 2 0 0 0 1 6 0 0 0 04 0 0 0 8 0 0 0 0 1 0 0 0 0 8 0 0 0 0 -6 0 0 0

Optimal Decision Rule:

A profit maximizing firm operating in perfectly competitive output and input markets will be using optimal amount of an input at the point at which the monetary value of the inputs marginal product is equal to the additional cost of using that input (L) - in other words, when MRP = MLC

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?

To illustrate this case we will use production isoquants. An isoquant is a curve showing all possible combinations of inputs physically capable of producing a given fixed level of output.

It is also known as Iso-Product Curve, Equal Product Curve, Production Indifference Curve

Example 2 Production Table

Units of KK Units of Employed Employed 8 7 6 5 4 3 2 1 Output Quantity (Q) Isoquant 83 96 107 117 127 128 78 90 101 110 119 120 64 73 82 90 97 104 58 67 75 82 89 95 52 60 67 73 79 85 41 52 58 64 69 73 29 39 47 52 56 52 14 20 27 24 21 17 3 4 5 6 7 8 Units of K Employed of L

37 42 37 31 24 17 8 4 1

60 64 52 47 39 29 18 8 2

An Isoquant
Gra ph of Isoqua nt Y 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 X

Substituting Inputs
There exists some degree of substitutability between inputs.
Different degrees of substitution: (Different Shapes)
Corn syrup Natural flavoring Capital
K1 K2 K3 K4
Q

Sugar
a) Perfect substitution Linear Isoquants

All other ingredients

L 1 L2

L3

L4

Labor

b) Perfect c) Imperfect substitution complementarity Right Angle Convex

Substituting Inputs continued

In case the two inputs are imperfectly substitutable, the optimal combination of inputs depends on the degree of substitutability and on the relative prices of the inputs

Substituting Inputs continued

The degree of imperfection in substitutability is measured with marginal rate of technical substitution (MRTS):

MRTS = L/ K
(in this MRTS some of L is removed from the production and substituted by K to maintain the same level of output)

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

Law of Diminishing Marginal Rate of Technical Substitution continued

Y 7 6 5 4 3 2 1 0 2 3 4 6 8 X
Y =- 2 X=1 Y = -1 X=1 Y = -1 X=2

A B C D E

MRTS = L/ K = - MPL/MPK
Units of K Employed 8 7 6 5 4 3 2 1 Output Quantity (Q) 83 96 107 117 127 128 78 90 101 110 119 120 64 73 82 90 97 104 58 67 75 82 89 95 52 60 67 73 79 85 41 52 58 64 69 73 29 39 47 52 56 52 14 20 27 24 21 17 3 4 5 6 7 8 Units of K Employed of L

37 42 37 31 24 17 8 4 1

60 64 52 47 39 29 18 8 2

M P / L M P K in R e la t io n t o M R T S ( X f o r Y ) M C o m b in a Qio n L M P L K M P KM R T S ( L Mo Pr/ LK ) P K t f A 52 6 2 B 5 2 4 1 3 3 6 ,5 2 2 C 52 3 11 4 11 1 1 D 5 2 2 6 ,5 6 1 3 1 /2 1 /2

The Production Isocost

The isocost function is the set of all combinations of capital and labour that can be purchased for a specified total cost. C= rK + wL (r=Price of K w=price of L)
Rate of capital

16.7

C=Rs.50
13.3

10

C=Rs.40 C=Rs.30 15 20 25 Rate of labour

Changes in the budget amount, C cause the isocost line to shift in a parallel manner. Changes in either the price of labour or capital cause both the slope and one intercept of the isocost function to change.
Rate of capital

C=Rs.40

40/2 40/3

40/2

Rate of labour

40/5

40/5

40/3

Optimal Decision Rule

Efficient production requires that the isoquant function be tangent to the isocost funtion at this point; MPL = MPK Rate of k w r

Rate of L

Optimal Decision Rule

There are three ways approaching to optimal resource allocation

Maximize

production for a given rupee outlay on L and K Minimize the rupee outlay on L and K to produce specified rate of output Produce the output rate that maximizes profit.

Constr ained optimi zation proble m

Optimal Decision Rule

Rate of K

a Rs.150 d Rs.100 20 b c 10

Rate of L

Optimal decision Rule

If the condition for efficient production is not met, there is some way to substitute one input for the other that will result in an increase at no change in total cost. Profit maximization requires that inputs be hired until MRPK=r and MRPL=w

Economies of Scale

Economies of Scale
A

given rate of input of K and L defines the scale of production. changes in both inputs

Change in Scale
Proportionate

Return to scale
The

magnitude of the change in the rate of output relative to the change in scale.
For eg. P.F. is Q= f(K,L) then hQ= f(K,L)
h factor change in output when factor change in both variable

Return to Scale

Increasing return to scale Output increase more than proportion to the change in inputs.

here, h > ( + b> 1)

Decreasing return to scale Output increase less than in proportion to the change in inputs.

here, h < ( + b<1)

Constant return to scale Output changes in the same proportion to the change in inputs.

here, h = ( + b=1)

Sources of Economies of Scale

Reasons for increase Reasons for decrease in ROS in ROS

Technologies Specialization of labour Inventory economy (increase or replacement)

Poor mgt. with the growth of the firm. Transportation cost Employing large no. of local labour force.

Economies of Scope

It refers to per-unit cost reductions that occur when a firm produces two or more products instead of just one. Firm can make use of its;
Excess

capacity Unique skill or comparative advantage in marketing to develop complementary products.

For eg. :- P&G sells all kinds of cleaning products as well some are complementary such as laundry det., bleach, and fabric softeners.

Measure of economies of scale

S =TC(QA) + TC(QB) TC(QA,QB) TC(QA,QB)

Estimating production function