You are on page 1of 38

PRODUCTION THEORY AND ANALYSIS- I (ONE VARIABLE INPUT

)

PRODUCTION
Transformation of I/Ps or resources into O/P of goods and services

FACTORS AFFECTING PRODUCTION

• Technology • Inputs

• Time period of production

FACTORS OF PRODUCTION INPUTS FACTOR INPUTS NON-FACTOR INPUTS Raw materials and other goods from other producing units Land Inelastic Immobile Heteroge neous Labor Active Mobile Variable Producti vity Capital Enterprise Structures Equipment Innovative Risk Decision making SECONDARY INPUTS PRIMARY INPUTS .

Plant. Machinery • Variable input: quantity can be changed Example: Labour. raw material .INPUT CLASSIFICATION • Fixed input: qty can not be readily changed Example: Building.

it is important to distinguish between two time frames – Short-run production function assumes that at least one of the inputs is fixed – Long-run production function assumes that all inputs adjust .PRODUCTION FUNCTION When analyzing production.

LEVEL & SCALE OF PRODUCTION • Level of production can be altered changing the proportion of variable inputs Output = Fixed inputs + Variable inputs • Scale of production can be altered by changing the supply of all the inputs only in the long run Output = Total inputs (variable inputs) .

PRODUCTION FUNCTION Technological relationship showing diff combinations of I/Ps that can produce max O/P within a given time period with a given technology .

...Xk) – Q is the level of output – X1..Xk are the levels of the inputs in the production process – f( ) represents the production technology ..X2.PRODUCTION FUNCTION Mathematically....X2. the production function can be expressed as Q=f(X1.

K) • Q is output • L is Labor • K is Capital .PRODUCTION FUNCTION • For simplicity. consider a production function of two inputs: Q=f (L.

• Variable proportions production: O/P can be changed by changing the I/Ps i.e. same O/P can be produced using diff combinations of I/Ps • Fixed proportions production: combination of I/Ps to produce a given O/P fixed .

HYPOTHETICAL PRODUCTION FUNCTION LABOUR 6 5 4 3 2 1 46 50 45 35 15 5 1 61 65 60 50 30 20 2 OUTPUT 80 85 80 70 50 40 3 88 95 90 80 60 50 4 CAPITAL 95 100 96 85 65 55 5 86 90 85 75 55 45 6 .

• Technical efficiency: maximum amount of O/P with a given combination of inputs • Economic efficiency: Producing a given O/P at the lowest possible cost. .

SHORT RUN ANALYSIS OF PRODUCTION FUNCTION.ONE VARIABLE INPUT .

PRODUCTION FUNCTION Q = f (L.K) Firm has chosen the level of capital so K is fixed in amount .

CONCEPT OF PRODUCT • Total Product .total volume of O/P resulting from use of different quantities of I/Ps • Average Product .the per unit product of a variable factor • Marginal Product .the rate at which total product changes/ change in TP resulting from a unit change in quantity of variable factor .

CONCEPT OF PRODUCT Total Product Marginal Product Average Product Production or Output Elasticity TP = Q = f(L) TP MPL = L TP APL = L MPL EL = AP L .

HYPOTHETICAL PRODUCTION FUNCTION LABOUR 6 5 4 3 2 1 46 50 45 35 15 5 1 61 65 60 50 30 20 2 80 85 80 70 50 40 3 OUTPUT 88 95 90 80 60 50 4 CAPITAL 95 100 96 85 65 55 5 86 90 85 75 55 45 6 .

EXCERCISE Variable Input Total Product (X) (Q or TP) 0 0 1 8 2 18 3 29 4 39 5 47 6 52 7 56 8 52 Calculate values of MP & AP .

CALCULATION OF MARGINAL PRODUCT Variable Marginal Input Total Product Product (X) (Q or TP) (MP) 0 0 8 1 8 10 2 18 11 3 29 10 4 39 8 Q 5 5 47 ΔX=1 ΔQ=5   5 X 1 6 52 4 7 56 -4 8 52 .

5 .67 4 39 9.67 7 56 8 8 52 6.CALCULATION OF AVERAGE PRODUCT Variable Total Average Input Product Product (X) (Q or TP) (AP) 0 0 --1 8 8 2 18 9 3 29 9.75 5 47 9.4 6 52 8.

EXERCISE II Find Marginal Product.DO YOURSELF. Average Product & Output Elasticity of labour L 0 1 2 3 4 5 6 Q 0 3 8 12 14 14 12 MPL 3 5 4 2 0 -2 AP 3 4 4 3. 2. 2 .

5 2.25 3 4 5 6 12 14 14 12 4 2 0 -2 4 3.SOLUTION L Q MPL APL EL 0 1 2 0 3 8 3 5 3 4 1 1.8 2 1 0.57 0 -1 .

LAW OF VARIABLE PROPORTIONS As more & more units of some factors of production are employed with some fixed factor then initially TP increases at an increasing rate. then at a decreasing rate & finally decreases .

EXAMPLE VARIABLE I/P (L) 0 1 2 3 4 5 TP 0 5 15 35 45 50 MP 5 10 20 10 5 AP 5 7.5 11.67 11.5 .25 10 6 45 -5 7.

THE LAW OF DIMINISHING RETURNS & STAGES OF PRODUCTION Total 16 Product 14 D E C 12 10 8 6 4 2 F TP B A Marginal & Average Product 0 6 5 4 3 2 1 0 -1 -2 -3 0 1 2 3 4 5 6 Labor 7 B’ A’ C’ D’ E’ F’ AP 0 1 2 3 4 5 6 7 MP Labor .

THE LAW OF DIMINISHING RETURNS & STAGES OF PRODUCTION Total Product 16 14 12 10 8 6 4 2 0 1 2 ’ 3 4 5 6 TP Marginal & Average Product 6 5 4 3 2 1 0 -1 -2 -3 0 Stage I Stage II Stage III Labor7 AP 1 2 3 4 5 6 7 MP Labor .

at some point the additional output (i. . marginal product) starts to diminish.e.THE LAW OF DIMINISHING RETURNS • Why does MP eventually decline? – Due to the law of diminishing return or as additional units of a variable input are combined with a fixed input..

– MP=AP when AP is maximum .RELATIONSHIP B/W AP & MP – If MP > AP then AP is rising. – If MP < AP then AP is falling.

• If MP is negative then TP is decreasing. • TP reaches a maximum when MP=0 (Maximization Condition!) Max .RELATIONSHIP B/W TP & MP • If MP is positive then TP is increasing.

STAGES OF PRODUCTION Q Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns Q=F(K.L) MP AP L .

THREE STAGES OF PRODUCTION – Stage I (increasing returns) • From zero units of the variable input to where AP is maximized – Stage II (diminishing returns) • From the maximum AP to where MP=0 – Stage III (negative returns) • From where MP=0 on where MP < 0 .

THREE STAGES OF PRODUCTION • In the short run. rational firms should only be operating in Stage II. – Why Stage II? • Why not Stage I? • Under utilising fixed capacity •Why not Stage III? • Over utilising fixed capacity .

OPTIMAL USE OF THE VARIABLE INPUT Marginal Revenue Product of Labor Marginal Resource Cost of Labor MRPL = (MPL)(MR) TC = W MRCL = L Optimal Use of Labor MRPL = MRCL .

50 4 4.50 4 3 2 1 0 10 10 10 10 10 20 20 20 20 20 Assumption : Firm hires additional units of labor at constant wage rate .50 3 3.EXERCISE: FINDING OPTIMAL VARIABLE I/P L MPL MR MRCL 2.

SOLUTION L 2.50 3.50 .00 4.50 MP L 4 3 2 1 0 MR = P 10 10 10 10 10 MRP L 40 30 20 10 0 MRC L 20 20 20 20 20 Use of Labor is Optimal When L = 3.50 4.00 3.

(b) What labour rate is optimal if the wage rate is increased to Rs 3 per unit. price of output is Rs 6 per unit & wage rate is Rs 2 per unit (a) determine the optimal labour to be hired. .5 Assume that capital stock is fixed at 9 units.EXERCISE Production function for Global electronics: Q = 2 K 0.5 L 0.

L employment falls. .SOLUTION (a) Rule: MRPL = MRCL = w MRPL = (MPL)(MR) = 18/√L W=2 So L = 81 (b) L = 36 As the wage rate increase.