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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
Production involves transformation of
inputs such as capital, equipment, labor,
and land into output - goods and services
Production theory can be divided into
short run theory or long run theory.
Long run and short run:
The Long Run is distinguished from the short
run by being a period of time long enough for
all inputs, or factors of production, to be
variable as far as an individual firm is
concerned
The Short Run, on the other hand, is a period
so brief that the amount of at least one input
is fixed
The length of time necessary for all inputs to
be variable may differ according to the nature
of the industry and the structure of a firm
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. The total
product curve for different technology is given
below.
Q
Q = output
x = inputs
x
Production Function continued
Q = f(L, K)
DEFINITIONS:
In the short run, capital is held constant.
Average product is total product divided by
the number of units of the input
Marginal product is the addition to total
product attributable to one unit of variable
input to the production process fixed input
remaining unchanged.
MP = TPN – TPN-1
Short run
labour Total Average Marginal
product product product
1 10 10 10
2 24 12 14
3 39 13 15
4 52 13 13
5 61 12.2 9
6 66 11 5
7 66 9.4 0
8 64 8 -2
Marginal and Average product:
Marginal product at any point is the slope of
the total product curve
Average product is the slope of the line
joining the point on the total product curve to
the origin.
When Average product is maximum, the
slope of the line joining the point to the origin
is also tangent to it.
P: Maximum Average Product
Q & R : Same Average Product
Both AP and MP first rise, reach a maximum
and then fall.
MP = AP when AP is maximum.
MP may be negative if Variable input is used
too intensively.
Law of diminishing marginal
productivity states that in the short run if
one input is fixed, the marginal product of the
variable input eventually starts falling
Law of Diminishing Returns
(Diminishing Marginal Product)
APX
MPX X
Section 2:
30 10 20 c
6 30 d
25 4 50 e
b
20
15
c
10 d
0
fig
0 5 10 15 20 25 30 35 40 45 50
Units of labour (L)
Isoquants and the Production Function
MPL w
MRTS LK
MPK r
Minimizing Cost subject to given Output
Expansion Path
If we imagine a set of isoquants representing
each possible rate of output, and given the
relative cost of resources, we can then draw
isocost lines to determine the optimal
combination of resources for producing each rate
of output
Expansion Path leads to Total Cost Curve
An expansion path is a long-run concept
(because all inputs can change)
Each point on the expansion path
represents a cost-minimizing combination
of inputs
Given input prices, each point represents
a total cost of producing a given level of
output when the entrepreneur can choose
any input combination he or she want
Expansion Path
If the relative prices of resources change, the
least-cost resource combination will also change
the firm’s expansion path will change
b 500
2
400
a
1
300
200
0
0 1 fig 2 3
Units of labour (L)
4 Increasing returns to scale (beyond
point b) R
c
3 700
Units of capital (K)
600
b
2
500
400
a
1
300
200
0
0 1 fig 2 3
Units of labour (L)
4 Decreasing returns to scale
(beyond point b) R
c
3 500
Units of capital (K)
b
2
400
a
1
300
200
0
0 1 fig 2 3
Units of labour (L)
Returns to Scale Shown on the Isoquant
Map
Economic Region of Production
There are certain combinations of inputs that the firm
should not use in the long run no matter how cheap
they are (unless the firm is being paid to use them)
These input combinations are represented by the
portion of an isoquant curve that has a positive slope
Economic Region of Production
A positive sloped isoquant means that merely to
maintain the same level of production, the firm must
use more of both inputs if it increases its use of one
of the inputs
The marginal product of one input is negative, and
using more of that input would actually cause output
to fall unless more of the other input were also
employed.
Economic Region of Production
Ridge Lines – are lines connecting the points where
the marginal product of an input is equal to zero in
the isoquant map and forming the boundary for the
economic region of production
Economic Region of Production – is the range in
an isoquant diagram where both inputs have a
positive marginal product. It lies inside the ridge lines
Homogeneous Production function:
If both factors of production are increased by
proportion λ, and if new level of output Q*
can be expressed as a function of λ to any
power v, and the initial output ,
i.e. Q* = λV Q
then the function is homogeneous and v is the
degree of homogeneity.
For example , check the function Q = 4L+3K2
If the production function is homogeneous ,
the expansion path is a straight line.
Check the homogeneity of the following
functions:
Q = 4L +3K
Q= 4KL
Q =4KL+K
A simple production function is the
Cobb-Douglas form
Three parameters: A, , and
q A L K
The Cobb-Douglas production function has
CRS if +=1
The Cobb-Douglas production function has
increasing (decreasing) returns to scale if
+
If ==½, we have the square root production
function
ISOCLINE:
An isocline is a locus of points along which
MRTS is constant.
An expansion path is also an isocline.
An isocline is a straight line if the production
function is homogeneous
Cobb – Douglas Production Function:
Q =AKαLβ
If α+ β= 1 , we have CRS
> 1 , we have IRS
< 1, we have DRS
Check Q = L2K2