PRODUCTION

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 CONCEPTS

• Production Function

• Short and Long Run Production Function

• Marginal Rate of Technical Substitution

• Productivity

• Isoquants

• Returns to scale

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 WHY DO FIRMS EXIST?

Core question
• Why do firms exist?
Firms help in coordinating the activities of a market
• They help in reducing the transaction costs in a market
• If everyone had to produce items individually and sell it, it would lead to high inefficiency
• Therefore a firm helps in ‘coordination’
• They reduce the multiple transactions that individuals would have to go through
• In industrial economics this is broadly called the ‘theory of the firm’

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 CORE COMPONENTS OF A FIRM

• The objective of a firm is to bring together individuals who can produce goods and services
• They convert inputs into outputs
• The process by which this conversion happens is based on:
• Production Technology
• How much labour versus capital to use to produce the same output
• Cost Constraint
• Firms should consider the prices of these goods
• Input Choice
• Given technology and prices of inputs, what should be the appropriate input mix?

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 WHAT DO FIRMS DO?

• Firms take a set of inputs and convert them to a specific output

• The inputs that a firm uses are called ‘factors of production’
• Inputs are generally classified into three parts
• Labor
• Capital
• Technology (latest addition in economics literature!)
• The objective of the firm is to maximize production using an optimal combination of all inputs possible

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PRODUCTION FUNCTION

 
• Highest output ‘q’ that can be produced with a combination of inputs
• Varying inputs
• Labor intensive (agriculture)
• Capital intensive (industries)
• For a given state of technology, a certain output can be manufactured. As technology improves, greater output
is produced with same set of inputs
• Short run
• Fixed inputs (at least one factor of input in fixed)
• Long run
• Inputs can be varied

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 SHORT RUN VERSUS LONG RUN

• In the short run, the firms cannot change (do not have the flexibility) to change the factors of
production
• In essence, in the short run, at least one factor of production is held constant.
• That factor of production is called the ‘fixed input’
• In the long-run the firm has the flexibility to change all factors of production
• The difference between the short-run and the long-run varies from firm to firm

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 AVERAGE AND MARGINAL PRODUCT

 
• Average Product of Labor/capital
• It is defined by the total amount of output produced by the total amount of labor/capital used in
the process

• Marginal Product of Labor/capital

• It is defined by the extra unit of output produced by an additional unit of labor/capital

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 EXAMPLE
L K
0 10 0 - -
1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 -4
10 10 100 10 -8

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 EXERCISE

INPUT OUTPUT MARGINAL PRODUCT AVERAGE PRODUCT

0 0

1 225

2 300

3 300

4 1140

5 225

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 RELATION BETWEEN THE AVERAGE AND MARGINAL

 
• When marginal product is greater than average product, the average product increases
• When the marginal product is lower than the average product, the average product decreases
• When is
• When is at its maximum
• Why does increase then decrease?
• Diminishing Marginal returns
• After a point becomes negative
• This happens when total production starts to decline
• = Slope of the line drawn from the origin to the corresponding point on the Total product curve
• = Slope of the total product at that point

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Note that when the marginal product curve is above
the average product, the average product is
increasing.
When the labor input is greater than 5 units, the
marginal product is below the average product, so
the average product is falling. Once the labor input
exceeds 9 units, the marginal product becomes
negative, so that total output falls as more labor is
added.
At C, when total output is maximized, the slope of
the tangent to the total product curve is 0, as is the
marginal product.
Beyond that point, the marginal product becomes
negative.
 READINGS

• Chapter 6 of Microeconomics (Pindyck & Rubinfeld)

• Section 6.1 & 6.2

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