Profits and The Aims of The Firm Long-Run and Short-Run Production: The Law of Diminishing Returns The Short-Run Production Function

SHORT-RUN THEORY OF PRODUCTION
• Profits and the aims of the firm

• Long-run and short-run production:
– fixed and variable factors
• The law of diminishing returns
• The short-run production function:
– total physical product (TPP)
– average physical product (APP)
– marginal physical product (MPP)
– the graphical relationship between TPP, APP
and MPP
Wheat production per year from a particular farm (tonnes)
Wheat production per year from a particular farm
Number of
40 workers TPP
0 0
Tonnes of wheat produced per year
1 3
2 10
3 24
30
4 36
5 40
6 42
7 42
20 8 40
10
0
0 1 2 3 4 5 6 7 8
Number of farm workers
40
TPP
30
20
10
0
0 1 2 3 4 5 6 7 8
40
TPP
30
Diminishing returns
set in here
20
b
10
a
0
0 1 2 3 4 5 6 7 8
d
40
TPP
30 Maximum output
20
b
10
a
0
0 1 2 3 4 5 6 7 8
40
Tonnes of wheat per year

TPP
30
20
10
∆ TPP = 7
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14 ∆ L=1
12
10
8
MPP = ∆ TPP / ∆ L = 7
6
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
40

TPP
30
20
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
12
10
0 Number of
-2
0 1 2 3 4 5 6 7 8 farm workers (L)
MPP
40

TPP
30
20
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
12 APP = TPP / L
10
4 APP
2
0 Number of
-2
0 1 2 3 4 5 6 7 8 farm workers (L)
MPP
40

TPP
30
20
b
Diminishing returns
10 set in here
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
12
10
4 APP
2
0 Number of
-2
0 1 2 3 4 5 6 7 8 farm workers (L)
MPP
d
40

TPP
30
20
Maximum
b output
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
12
10
4 APP
2
0 d Number of
-2
0 1 2 3 4 5 6 7 8 farm workers (L)
MPP
d
40
c

Slope = TPP / L TPP
30
= APP
20
b
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
12
10
c
8
4 APP
2
0 d Number of
-2
0 1 2 3 4 5 6 7 8 farm workers (L)
MPP
LONG-RUN THEORY OF PRODUCTION
• All factors variable in long run

• The scale of production:
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
• Economies of scale
– specialisation & division of labour
– indivisibilities
– container principle
– greater efficiency of large machines
– by-products
– multi-stage production
– organisational & administrative economies
– financial economies
– economies of scope
• Diseconomies of scale
• External economies and diseconomies of

scale
• Optimum combination of factors

MPPa/Pa = MPPb/Pb ... = MPPn/Pn
ISOQUANT- ISOCOST ANALYSIS
• Isoquants
– their shape
– diminishing marginal rate of substitution
– isoquants and returns to scale
– isoquants and marginal returns
• Isocosts
– slope and position of the isocost
– shifts in the isocost
An isoquant
45
40 a
Units Units Point on
of K of L diagram
35 40 5 a
20 12 b
30
Units of capital (K)
10 20 c
6 30 d
25 4 50 e
20
15
10
0
0 5 10 15 20 25 30 35 40 45 50
Units of labour (L)
An isoquant
45
40 a
of K of L diagram
35 40 5 a
20 12 b
30
10 20 c
6 30 d
25 4 50 e
b
20
15
10
0
0 5 10 15 20 25 30 35 40 45 50
Units of labour (L)
An isoquant
45
40 a
of K of L diagram
35 40 5 a
20 12 b
30
10 20 c
6 30 d
25 4 50 e
b
20
15
c
10
d
5 e
0
0 5 10 15 20 25 30 35 40 45 50
Units of labour (L)
Diminishing marginal rate of factor substitution
14
12 g
∆ K=2
MRS = 2 MRS = ∆ K / ∆ L
10 h
∆ L=1
8
2
isoquant
0
0 2 4 6 8 10 12 14 16 18 20
Units of labour (L)
Diminishing marginal rate of factor substitution
14
12 g
∆ K=2
MRS = 2 MRS = ∆ K / ∆ L
10 h
∆ L=1
8
j MRS = 1
∆ K=1 k
6
∆ L=1
4
2
isoquant
0
0 2 4 6 8 10 12 14 16 18 20
Units of labour (L)
An isoquant map
30
20
10
I1
0
0 10 20
Units of labour (L)
An isoquant map
30
20
10
I2
I1
0
0 10 20
Units of labour (L)
An isoquant map
30
20
10
I3
I2
I1
0
0 10 20
Units of labour (L)
An isoquant map
30
20
10
I4
I3
I2
I1
0
0 10 20
Units of labour (L)
An isoquant map
30
20
10
I5
I4
I3
I2
I1
0
0 10 20
Units of labour (L)
An isocost
30
Assumptions
25
PK = £20 000
20 W = £10 000
TC = £300 000
a
15
10
5
TC = £300 000
0
0 5 10 15 20 25 30 35 40
Units of labour (L)
An isocost
30
Assumptions
25
PK = £20 000
20 W = £10 000
TC = £300 000
a
15
b
10
5
TC = £300 000
0
0 5 10 15 20 25 30 35 40
Units of labour (L)
An isocost
30
Assumptions
25
PK = £20 000
20 W = £10 000
TC = £300 000
a
15
b
10
c
5
TC = £300 000
0
0 5 10 15 20 25 30 35 40
Units of labour (L)
An isocost
30
Assumptions
25
PK = £20 000
20 W = £10 000
TC = £300 000
a
15
b
10
c
5
TC = £300 000
d
0
0 5 10 15 20 25 30 35 40
Units of labour (L)
ISOQUANT- ISOCOST ANALYSIS
• Least-cost combination of factors for a

given output
– point of tangency
– comparison with marginal productivity
approach
• Highest output for a given cost of

production
Finding the least-cost method of production
35
Assumptions
30
PK = £20 000
W = £10 000
25
TC = £200
20 000
TC = £300 000
15
TC = £400 000
10
TC = £500 000
0
0 10 20 30 40 50
Units of labour (L)
35
30
25
20
15
10
5 TPP1
0
0 10 20 30 40 50
Units of labour (L)
35
30
25
20
15
TC = £400 000
r
10
5 TPP1
0
0 10 20 30 40 50
Units of labour (L)
35
30
25
s
TC = £500 000
20
15
TC = £400 000
r
10
t
5 TPP1
0
0 10 20 30 40 50
Units of labour (L)
Finding the maximum output for a given total cost
TPP5
TPP4
TPP3
TPP2
TPP1
O
Units of labour (L)
Isocost
TPP5
TPP4
TPP3
TPP2
TPP1
O
Units of labour (L)
r
TPP5
TPP4
v TPP3
TPP2
TPP1
O
Units of labour (L)
r
s
u TPP5
TPP4
v TPP3
TPP2
TPP1
O
Units of labour (L)
r
s
u TPP5
TPP4
v TPP3
TPP2
TPP1
O
Units of labour (L)
r
s
K1
t
u TPP5
TPP4
v TPP3
TPP2
TPP1
O L1
Units of labour (L)

Profits and The Aims of The Firm Long-Run and Short-Run Production: The Law of Diminishing Returns The Short-Run Production Function

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Profits and The Aims of The Firm Long-Run and Short-Run Production: The Law of Diminishing Returns The Short-Run Production Function

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SHORT-RUN THEORY OF PRODUCTION

• Profits and the aims of the firm

Tonnes of wheat per year

Tonnes of wheat per year

Tonnes of wheat per year

Tonnes of wheat per year

Tonnes of wheat per year

Tonnes of wheat per year

• All factors variable in long run

• External economies and diseconomies of

• Optimum combination of factors

• Least-cost combination of factors for a

• Highest output for a given cost of

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