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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
Land Labor Capital Enterprise and other goods
Inelastic Active Structures Innovative from other
Immobile Mobile Equipment Risk
Heteroge producing units
Variable Decision
neous Producti making
vity SECONDARY INPUTS

PRIMARY INPUTS
INPUT CLASSIFICATION

• Fixed input: qty can not be readily changed


Example: Building, Plant, Machinery

• Variable input: quantity can be changed


Example: Labour, raw material
PRODUCTION FUNCTION
When analyzing production, 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
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
PRODUCTION FUNCTION
Mathematically, the production function can be
expressed as

Q=f(X1,X2,...,Xk)

– Q is the level of output


– X1,X2,...,Xk are the levels of the inputs in the
production process
– f( ) represents the production technology
PRODUCTION FUNCTION
• For simplicity, consider a production function of two
inputs:

Q=f (L,K)
• Q is output
• L is Labor
• K is Capital
• 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: fixed


combination of I/Ps to produce a given O/P
HYPOTHETICAL PRODUCTION FUNCTION
LABOUR OUTPUT
6 46 61 80 88 95 86
5 50 65 85 95 100 90
4 45 60 80 90 96 85
3 35 50 70 80 85 75
2 15 30 50 60 65 55
1 5 20 40 50 55 45
1 2 3 4 5 6
CAPITAL
• 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 TP = Q = f(L)


∆TP
Marginal Product MPL =
∆L
Average Product TP
APL =
L
Production or MPL
EL =
Output Elasticity APL
HYPOTHETICAL PRODUCTION FUNCTION
LABOUR OUTPUT

6 46 61 80 88 95 86

5 50 65 85 95 100 90

4 45 60 80 90 96 85

3 35 50 70 80 85 75

2 15 30 50 60 65 55

1 5 20 40 50 55 45

1 2 3 4 5 6

CAPITAL
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
5 47 ∆Q 5
ΔX=1 ΔQ=5 = = 5
6 52 ∆X 1
4
7 56
-4
8 52
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 9.67
4 39 9.75
5 47 9.4
6 52 8.67
7 56 8
8 52 6.5
DO YOURSELF- EXERCISE II

Find Marginal Product, Average Product & Output


Elasticity of labour
L Q MPL AP
0 0 - -
1 3 3 3
2 8 5 4
3 12 4 4
4 14 2 3.
5 14 0 2.
6 12 -2 2
SOLUTION

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
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 TP MP AP
I/P (L)
0 0 - -
1 5 5 5
2 15 10 7.5
3 35 20 11.67

4 45 10 11.25

5 50 5 10
6 45 -5 7.5
THE LAW OF DIMINISHING RETURNS &
STAGES OF PRODUCTION

Total 16
Product D E
14
C F
12
TP
10
B
8

4 A
2

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

16
14
12 TP
10
8
6
4
2
0 1 2 3 4 5 6 Labor7
6
Marginal 5
Stage I Stage II Stage III

& 4
Average 3
Product 2
1
AP
0
0 1 2 3 4 5 6 7
-1
-2
MP Labor
-3
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, at some point the additional
output (i.e., marginal product) starts to diminish.
RELATIONSHIP B/W AP & MP

– If MP > AP then
AP is rising.

– If MP < AP then
AP is falling.

– MP=AP when
AP is maximum
RELATIONSHIP B/W TP & MP

• If MP is positive then TP
Ma
is increasing. x

• If MP is negative then
TP is decreasing.

• TP reaches a maximum
when MP=0
(Maximization
Condition!)
STAGES OF PRODUCTION

Q Increasing Diminishing Negative


Marginal Marginal Marginal
Returns Returns Returns

Q=F(K,L)

AP
L
MP
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 MRPL = (MPL)(MR)

Marginal Resource ∆TC = W


Cost of Labor MRCL =
∆L

Optimal Use of Labor MRPL = MRCL


EXERCISE: FINDING OPTIMAL VARIABLE I/P

L MPL MR MRCL

2.50 4 10 20

3 3 10 20

3.50 2 10 20

4 1 10 20

4.50 0 10 20

Assumption : Firm hires additional units of labor at constant


wage rate
SOLUTION

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

Use of Labor is Optimal When L = 3.50


EXERCISE

Production function for Global electronics:


Q = 2 K 0.5 L 0.5
Assume that capital stock is fixed at 9 units, price of
output is Rs 6 per unit & wage rate is Rs 2 per unit
(a) determine the optimal labour to be hired.
(b) What labour rate is optimal if the wage rate is
increased to Rs 3 per unit.
SOLUTION
(a) Rule: MRPL = MRCL = w
MRPL = (MPL)(MR) = 18/√L
W=2
So L = 81
(b) L = 36

As the wage rate increase, L employment falls.